GAO Report on Retirement Savings: Overall Gaps Identified, but the Focus of Retirement Security Reform Should be on the Uncovered Population

VanDerhei

VanDerhei

By Jack VanDerhei, EBRI

The Government Accountability Office’s new retirement analysis reviewed nine studies conducted between 2006 and 2015 by a variety of organizations and concluded that generally one-third to two-thirds of workers are at risk of falling short of their retirement savings targets.

However, many of these studies use a “replacement rate” standard: Most commonly, this analysis concludes that you need to replace 70–80 percent of your preretirement income to be assured of a successful retirement. This is a convenient metric to use to convey retirement targets to individuals—and no doubt provides useful information to many workers who are attempting to determine whether they are “on-track” with respect to their retirement savings and/or what their future savings rates should be. However, replacement rates are NOT appropriate in large-scale policy models for determining whether an individual will run short of money in retirement. Why?

Because simply setting a target replacement rate at retirement age and suggesting that anyone above that threshold will have a “successful” retirement completely ignores:

  1. Longevity risk.
  2. Post-retirement investment risk.
  3. Long-term care risk.

In fact, looking at just the first two risks above, if you use a replacement rate threshold based on average longevity and average rate of return, you will, in essence, have a savings target that will prove to be insufficient about 50 percent of the time. Of course, this would not be a problem if retirees annuitized all or a large percentage of their defined contribution and IRA balances at retirement age; but the data suggest that only a small percentage of retirees do this.

In contrast, EBRI has been working for the last 14 years to develop a far more inclusive, sophisticated, realistic—and, yes, complex—model that deals with all these risks. It’s our Retirement Security Projection Model® (RSPM), and produces a Retirement Readiness Rating (basically, the probability that a household will NOT run short of money in retirement).

Blog.JV.GAO-rpt.June15.Fig1Our most recent Retirement Readiness Ratings by age are shown in Figure 1 (left). Our baseline results do include long term care costs (the red bars), but we also run the numbers assuming that these costs are NEVER paid by the retirees (the green bars). This latter assumption is not likely to be realistic for many retirees, but we include it to show how important it is to include these costs (unlike many other models).

Even more important is Fig. 2 (right), which shows Retirement Readiness Ratings as a function of preretirement income AND the number of future years of eligibility for a defined contribution plan for Gen Xers.

Blog.JV.GAO-rpt.June15.Fig2Even controlling for the impact of income on the probability of a successful retirement, the number of future years that a Gen Xer works for an employer that sponsors a defined contribution plan will make a tremendous difference in their Retirement Readiness Ratings (even with long-term care costs included).

The evidence from EBRI’s simulation modeling certainly agrees with the GAO that a significant percentage of households will likely run short of money in retirement if coverage is not increased. However this is because we model all the major risks in retirement and do not simply assume some ad-hoc replacement rate threshold.

Moreover, using an aggregate number to portray the percentage of workers at risk for inadequate retirement income is really missing the bigger picture. The retirement security landscape for today’s workers can be bifurcated into those fortunate enough to work for employers that sponsor retirement plans for a majority of their careers vs. those who do not. In general, those who have an employer-sponsored retirement plan for most of their working careers appear to be well on their way to a secure retirement.

Perhaps the focus of any retirement security reform going forward needs to be on those who do not work for employers offering retirement plans and those in the lowest-income quartile.

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Jack VanDerhei is research director at the Employee Benefit Research Institute.

Safety “Net”

By Nevin Adams, EBRI

Nevin Adams

Nevin Adams

I’m one of those travelers who absolutely dreads cutting it to the last minute. Not that I haven’t been forced to do so, from time to time, but I’m generally the one chomping at the bit to get to the airport, or to hit the highway an hour before anyone else. In my defense, on more than one occasion that “cushion” has been the difference between catching a flight or not. Planning that only considers a “best” or “normal” scenario too often overlooks the unexpected—and sometimes that margin of error is all you have.

For over a decade EBRI has modeled the nation’s potential retirement savings shortfall, and the EBRI Retirement Readiness Ratings™ provide an assessment of how many Americans are at risk of running short of money for needed expenses in retirement. In contemplating expenses, that model considers the regular expenses of living in retirement, as well as uninsured medical expenses, and the potential costs of nursing home care.

However, we have also documented and quantified the role of Social Security, defined benefit and private retirement accounts on retirement income adequacy for Baby Boomers and Gen Xers with an eye toward replacing their preretirement wages and income. While this more traditional focus on income replacement may misstate an individual’s actual post-retirement financial situation, many financial planners work with this goal as a starting point, and it can provide valuable insights particularly when—as is the case with EBRI’s projections—it is able to leverage actual 401(k) data from the unique EBRI/ICI 401(k) database, the largest such repository in the world.

Indeed, based on a recent EBRI analysis, between 83 and 86 percent of workers with more than 30 years of eligibility in a voluntary enrollment 401(k) plan are simulated to have sufficient 401(k) accumulations that, combined with current levels of Social Security retirement benefits, will be able to replace at least 60 percent of their age-64 wages and salary on an inflation-adjusted basis. When the threshold for a financially successful retirement is increased to 70 percent replacement of age-64 income, 73–76 percent of these workers will still meet that threshold, relying only on 401(k) and Social Security combined. At an 80 percent replacement rate, 67 percent of the lowest-income quartile will still meet the threshold; however the percentage of those in the highest-income quartile deemed to be “successful” relying on just these two retirement components slips to 59 percent, reflecting the progressive nature of Social Security.

As positive a result as that seems for many, when the same analysis is conducted for automatic enrollment 401(k) plans (with an annual 1 percent automatic escalation provision and empirically derived opt-outs), the probability of success increases substantially: 88–94 percent at a 60 percent threshold; 81–90 percent at a 70 percent replacement threshold; and 73–85 percent at an 80 percent threshold.

That’s not quite the doomsday crisis scenario portrayed by many of the headlines in vogue today, though EBRI’s projections still show that a large number of Americans—even among those eligible for a 401(k) plan for 30 years—won’t be able to replace that pre-65 salary even at the various levels modeled, based on current savings patterns.

It does, however, illustrate the impact that changes in those current savings behaviors can have—and it underscores the significant role of Social Security as a vital safety net for the nation’s retirement security.

Note

“The Role of Social Security, Defined Benefits, and Private Retirement Accounts in the Face of the Retirement Crisis” is available online here.

“Better” Business?

By Nevin Adams, EBRI

Adams

Adams

It has become something of a truism in our industry that defined benefit plans are “better” than defined contribution plans. We’re told that returns are higher(1) and fees lower in the former, that employees are better served by having the investment decisions made by professionals, and that many individuals don’t save enough on their own to provide the level of retirement income that they could expect from a defined benefit pension plan. Even the recent (arguably positive) changes in defined contribution design—automatic enrollment, qualified default investment alternatives, and the expanding availability of retirement income options(2)—are often said to represent the “DB-ification” of DC plans.

However, a recent analysis by EBRI reveals that DB is not always “better,” at least not defined as providing financial resources in retirement. In fact, if historical rates of return are assumed, as well as annuity purchase prices reflecting average bond rates over the last 27 years, the median comparisons show a strong outcome advantage for voluntary-enrollment (VE) 401(k) plans over both stylized, final-average DB plan and cash balance plan designs.(3)

Admittedly, those findings are based on a number of assumptions, not the least of which include the specific benefit formulae of the DB plans, and the performance of the markets. Indeed, the analysis in the June EBRI Issue Brief takes pains not only to outline and explain those assumptions,(4) but, using EBRI’s unique Retirement Security Projection Model® (RSPM) to produce a wide range of simulations, provides a direct comparison of the likely benefits in a number of possible scenarios, some of which produce different comparative outcomes. While the results do reflect the projected cumulative effects of job changes and things like loans, as well as the real-life 401(k) plan design parameters in several hundred different plans, they do not yet incorporate the potentially positive impact that automatic enrollment might have, particularly for lower-income individuals.

Significantly, the EBRI report does take into account another real-world factor that is frequently overlooked in the DB-to-DC comparisons: the actual job tenure experience of those in the private sector. In fact, as a recent EBRI Notes article(5) points out, the data on employee tenure (the amount of time an individual has been with his or her current employer) show that so-called “career jobs” NEVER existed for most workers. Indeed, over the past nearly 30 years, the median tenure of all wage and salary workers age 20 or older has held steady, at approximately five years. Even with today’s accelerated vesting schedules, that kind of turnover represents a kind of tenure “leakage” that can have a significant impact on pension benefits—even when they work for an employer that offers that benefit, they simply don’t work for one employer long enough to qualify for a meaningful benefit.

So, which type of retirement plan is “better”? As the EBRI analysis illustrates, there is no single right answer—but the data suggests that ignoring how often people actually change employers can be as misleading as ignoring how much they actually save.

Notes

(1) In the days following publication of the EBRI Issue Brief, (“Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here),  a number of individuals commented specifically on the chronicled difference in return in DB and DC plans; outside of some exceptions in the public sector, DB investment performance generally has no effect on the benefits paid.

(2) A recent EBRI analysis indicates that, even in DB plans, the rate of annuitization varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

(3) While the DC plans modeled in this analysis draw from the actual design experience of several hundred VE 401(k) plans, in the interest of clarity it was decided to limit the comparisons for DB plans to only two stylized representative plan designs: a high-three-year, final-average DB plan and a cash balance plan. Median generosity parameters are used for baseline purposes but comparisons are also re-run with more generous provisions (the 75th percentile) as part of the sensitivity analysis.

(4) The report notes that a multitude of factors affect the ultimate outcome: interest rates and investment returns; the level and length of participation; an individual’s age, job tenure, and remaining length of time in the work force; and the purchase price of an annuity, among other things.

(5) The EBRI report highlights several implications of these tenure trends: the effect on DB accruals (even for workers still covered by those programs), the impact of the lump-sum distributions that often accompany job change, and the implications for social programs and workplace stability. “See Employee Tenure Trends, 1983–2012,” online here.

Puzzle Picture

By Nevin Adams, EBRI

Adams

Adams

One of my favorite memories of visiting my grandparents over the holidays was working on jigsaw puzzles. These were generally large, complicated affairs—whose construction was spread over days, as various family members would stop by to work on a section, to build on a border, or sometimes contribute a single piece they would spot as they drifted by on their way to another activity. Perched in a prominent place throughout would be the puzzle lid with that all-important picture of what we were working toward to help keep all those individual, and sometimes fleeting, efforts in the proper perspective, that made it possible to differentiate the blue of what would appear to be sky from what would turn out to be an important, but obscure section of mountain stream.

In retirement plans, one of the more intransigent concerns for policy makers, providers, and plan sponsors alike is what has been called the “annuity puzzle”—the reluctance of American workers to embrace annuities as a distribution option for their retirement savings. What economists call “rational choice theory”(1) suggests that at the onset of retirement individuals will be drawn to annuities, because they provide a steady stream of income, and address the risk of outliving their income. And yet, given a choice, the vast majority don’t.

Over the years, a number of explanations have been put forth to try and explain this reluctance: the fear of losing control of finances; a desire to leave something to heirs; discomfort with entrusting so much to a single insurer;, concern about fees; the difficulty of understanding a complex financial product; or simple risk aversion—all have been studied, acknowledged, and, in many cases, addressed, both in education and in product design, with little impact on take-up rates.

As defined contribution programs have grown, those frustrated with the tepid rate of annuity adoption have sought to bring employers into the mix by providing them (and the plans they sponsor) with a range of alternatives: so-called “in- plan” retirement income options, qualified default investment alternatives that incorporate retirement income guarantees, and expanded access to annuities as part of a distribution platform. In recent years, regulators have also entered the mix, among other things issuing a Request for Information (RFI) regarding the “desirability and availability of lifetime income alternatives in retirement plans,” conducting a two-day hearing on the topic, and (as recently as last year) issuing both final and proposed regulatory guidance.

Yet today the annuity “puzzle” remains largely unsolved. And, amidst growing concerns about workers outliving their retirement savings, a key question—both as a matter of national retirement policy and understanding the potential role of plan design and education in influencing individual decision-making—is how many retiring workers actually choose to take a stream of lifetime income, vs. opting for a lump sum.

As outlined in a new EBRI Issue Brief,(2) the evidence on annuitization in workplace pension plans has been mixed. But the EBRI report provides an important new perspective to a 2011 paper titled “Annuitization Puzzles” by Shlomo Benartzi, Alessandro Previtero, and Richard H. Thaler.(3)  In that paper, they analyzed 112 different DB plans provided by a large plan administrator and, focusing on those who retired between ages 50 and 75 with at least five years of job tenure and a minimum account balance of $5,000, and noted that “…virtually half of the participants (49 percent) selected annuities over the lump sum,” further observing that “When an annuity is a readily available option, many participants who have non-trivial account balances choose it.”

The study’s authors went on state that “The notion that consumers are simply not interested in annuities is clearly false,” explaining that “…the common view that there is little demand for annuities even in defined benefit plans is largely driven by looking at the overall population of participants, including young and terminated employees and others with small account balances who are either required to take a lump-sum distribution or simply decide to take the money.”

Mixed Behaviors?

In essence, Benartzi’s “Annuitization Puzzles” study says that much of the existing research draws inaccurate conclusions by mixing the behaviors of younger workers with smaller balances with those who might, based on their age and financial status, be expected to choose an annuity. However, as noted in the EBRI Issue Brief, that study failed to take into consideration what has long been known to be a key element in retirement plan behaviors: retirement plan design. In effect, the Benartzi study blends the behaviors of participants who have the ability to choose an annuity with those who have either no choice, or one restricted by their plan.

What kind of difference might this make? Well, taking into account the same types of filter on tenure, balance, and age employed by the Benartzi study, as well as a series of plan design restrictions, EBRI found that for traditional defined benefit plans(4) that imposed no restriction on doing so, fewer than a third of those with balances greater than $25,000 opted for an annuity, as did only about 1 in 5 whose balances were between $10,000 and $25,000. Those with balances between $5,000 and $10,000 were even less likely to do so.(5)  In sum, even filtering to focus on the behaviors of individuals seen as most likely to choose an annuity distribution, we found that, given an unfettered choice, the vast majority do not.

Ultimately, the EBRI analysis shows that, to a large extent, plan design drives annuitization decisions.(6)  We know that plan design changes have been successful in influencing participant behavior in DC plans via auto-enrollment and auto-escalation, and the new EBRI study suggests that plan design can also play a critical role in influencing distribution choices.

It also shows the importance of taking into account the whole picture when you’re trying to solve a puzzle.

Notes

(1) “Annuitization Puzzles,” by Shlomo Benartzi, Alessandro Previtero and Richard H. Thaler is online here.

(2) According to Investopedia, it is “…an economic principle that assumes that individuals always make prudent and logical decisions that provide them with the greatest benefit or satisfaction and that are in their highest self-interest.”

(3) See the January 2013 EBRI Issue Brief, no. 381, “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

(4) Participants in cash balance plans were even less likely to choose annuities than those in “traditional” final-average-pay defined benefit plans.

(5) The Benartzi study filtered only on individuals with a balance greater than $5,000.

(6) The EBRI analysis also found that annuitization rates increase steadily with account balance for older workers (but not for younger workers), and that annuitization rates also increase with tenure. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

Annuity Choice Driven by Pension Plan Rules

EBRI_IB_01-13.No381.Pg1_Page_01Why do some retiring workers with a pension choose to take a stream of lifetime income, while others cash out their entire benefit in a lump-sum distribution?

Amidst growing concerns about workers outliving their retirement savings, this has emerged as a key issue—and it depends to a large extent on whether the individual pension plan allows or restricts lump-sum distributions (LSDs), according to new research by EBRI. A better understanding of these decisions stands to shed light not only on the outcomes for traditional pensions, but also for defined contribution plans, where LSDs are the rule rather than the exception.

EBRI’s research, the first time this level of analysis has been done on this scale, reveals that differences in defined benefit (DB) plan rules or features result in very different annuitization rates. In fact, the results show that the rate of annuitization—the rate at which workers choose to take their benefit as an annuity—varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. In choosing an LSD, the individual takes on the investment risk and responsibility for managing the distribution, and, ultimately, arranging his or her own income flow in retirement from those funds.

Analyzing data from more than 80 different pension plans, EBRI compares the “annuitization rate” among individuals at various age, tenure, and account balances, along with the rules and distribution choices within individual pension plans. EBRI found that between 2005 and 2010, pension plans with no LSD distribution options had annuitization rates very close to 100 percent. In contrast, the annuitization rate for defined benefit and cash balance plans with no restrictions on LSDs was only 27.3 percent.

“Whether people annuitize depends to a large extent on whether or not they are allowed to choose some other option,” said Sudipto Banerjee, EBRI research associate and author of the study. “Any study of annuitization that fails to take into account the impact of plan design on participant choice will likely lead to misinterpretations.”

The report notes that through the 1960s DB pension plans offered mainly one distribution choice: a fixed-payment annuity. That changed beginning in the 1970s, as some DB plans began to offer the option of full or partial single-sum distributions, and as “hybrid” pension plans expanded in the 1980s, so did distribution options. Today, most DB pension plans offer some type of single/lump-sum option, in addition to the traditional annuity choice.

The full report is published in the January 2013 EBRI Issue Brief no. 381, “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online at www.ebri.org