Map “Quests”

Nevin AdamsBy Nevin Adams, EBRI

I’ve been hooked on the convenience of GPS systems ever since the first time one was included in the price of a rental car on a family trip in unfamiliar territory. After all, it combines the opportunity to tinker with electronic gadgetry alongside the convenience of not having to do much in the way of pre-planning trip routes—not to mention avoiding the need to stop and ask for directions (that is frequently associated with not doing much in the way of pre-planning trip routes).

There are, of course, horror stories about drivers who have blindly followed GPS instructions without paying attention to the evidence of their eyes. My family still chuckles at the memory of a trip where we were running late to our plane, and the rental car GPS, based on what appeared to be an outdated address for the return office, kept directing us to an address that was not only miles from the real office, but a place from which I wondered if we might never return.

As a growing number of Americans near, and head into, retirement, policymakers, retirement plan sponsors, and individual workers alike increasingly wonder—will Americans have enough to live on when they retire? Unfortunately, as a recent EBRI publication[1] explains, the answers provided are as diverse, and sometimes disparate, as the projection models that produce those results.

While it is not always clear from their results, some of those models limit their analysis to households already retired, while others focus on households still working, but old enough that reasonably accurate projections regarding their future wages and prospects for accumulating retirement wealth are obtainable. Still others attempt to analyze the prospects for all working households, including those whose relative youth (and distance from retirement) makes accurate, long-term predictions somewhat problematic.

Moreover, there are varied definitions of retirement income adequacy. As the EBRI report explains, some either (1) model only the accumulation side of the equation and then rely on some type of preretirement income replacement rate measure as a threshold for success, or (2) make use of a so-called “life-cycle” model that attempts to smooth/spread some type of consumption-based utility over the decision-maker’s lifetime.

The problem with the former is that, since very few households annuitize all (or even most) of their individual accounts in retirement, a replacement-rate focus overlooks the potential risk of outliving their income (longevity risk). And while the annuity purchase price relied upon in a replacement-rate target does depend on an implicit assumption with respect to (at least some) future market returns, it does not typically account for the potential investment risk. Additionally, and as previous EBRI research has demonstrated, one of the biggest financial obstacles in terms of maintaining retirement income adequacy for households that might otherwise have sufficient financial resources at retirement age is the risk of long-term care costs for a prolonged period. In the real world, few retirees have long-term care insurance policies in place that would cover the potentially catastrophic financial impact of this exposure—and thus, simply adding the cost of long-term care insurance into a replacement-rate methodology will vastly underestimate the potential severity of this exposure.

As for the life-cycle smoothing model, the EBRI report notes that approach typically produces extraordinarily low levels of “optimal” savings for low-income individuals at retirement, and while some households may, in fact, have no choice but to subsist at those levels in retirement, from a public policy perspective EBRI chose instead to establish a threshold that would allow households to afford average expenditures (for retirees in the appropriate income category) throughout their retirement, while at the same time accounting for the potential impact of uninsured long-term care costs.

EBRI’s Retirement Security Projection Model®[2] takes a different—arguably unique and more realistic—perspective. Rather than relying on an individual’s projected ability to achieve an arbitrarily designated percentage of his or her preretirement income as a proxy for retirement income adequacy, RSPM grew out of a multiyear project to analyze the future economic well-being of the retired population at the state level, focused on identifying the point at which individuals would run short of money and perhaps become a financial obligation of the state.

As valuable a resource as a GPS can be, it can quickly become a nuisance—or worse—if the input destination point is incorrect, or the mapping system is out of date. Similarly, those who want a financially secure retirement may find that relying on a model based on flawed assumptions or outdated “destinations” may find themselves short of their goal and with little time to do anything about it.

Notes

[1] See ““’Short’ Falls: Who’s Most Likely to Come up Short in Retirement, and When?” online here.

[2] A brief description of EBRI’s Retirement Security Projection Model® can be found online here.

Reality “Checks”

By Nevin Adams, EBRI

A recent opinion piece by Teresa Ghilarducci in the New York Times took on what she termed a “ridiculous approach to retirement,” drawn from what appears to be a series of “ad hoc” dinner conversations with friends about their “retirement plans and prospects.”

Most of the op-ed focused on the perceived shortfalls of the voluntary retirement savings system: People don’t have enough savings, don’t know how much “enough” is, make inaccurate assumptions about the length of their lives and their ability to extend their working careers, and aren’t able to find qualified help to help them make more appropriate savings decisions.   In place of the current system, which Ghilarducci maintains “will always fall short,” she proposes “a way out” via mandatory savings in addition to the current Social Security withholding.  Consider that, just three sentences into the op-ed, she posits the jaw-dropping statistic that 75 percent of Americans nearing retirement age in 2010 had less than $30,000 in their retirement accounts.

“You don’t like mandates?  Get real,” she declares.

When we looked across the EBRI database of some 2.3 million active1 401(k) participants at the end of 2010 who were between the ages of 56 and 65, inclusive – people who have chosen to supplement Social Security through voluntary savings – we found only about half that number (37 percent) with less than $30,000 in those accounts.  Moreover, when looking at those in that group who have more than 30 years of tenure, fewer than 13% are in that circumstance – and neither set of numbers includes retirement assets that those individuals may have accumulated in the plans of their previous employers, or that they may have rolled into Individual Retirement Accounts (IRAs), as well as pensions or other savings (see Average IRA Balances a Third Higher When Multiple Accounts are Considered).

That’s not to say that the financial challenges outlined in the op-ed won’t be a reality for some. In fact, EBRI’s Retirement Security Projection Model® (RSPM) developed in 2003, updated in 20102, finds that for Early Baby Boomers (individuals born between 1948 and 1954), Late Baby Boomers (born between 1955 and 1964) and Generation Xers (born between 1965 and 1974), roughly 44 percent of the simulated lifepaths were projected to lack adequate retirement income for basic retirement expenses plus uninsured health care costs (see “Retirement Income Adequacy for Boomers and Gen Xers: Evidence from the 2012 EBRI Retirement Security Projection Model”) .

The op-ed declares that a voluntary Social Security system “would have been a disaster.”  Indeed, an objective observer might conclude that that is why Congress originally established Social Security as a mandatory system, to provide a base of income for retirees as it still does today.   With the underpinnings of that mandatory foundation of Social Security, the current voluntary system was established to allow employers and individuals to supplement that base.  In recent decades Social Security’s benefits have been “reduced” by increases in the definition of normal retirement age, and a partial taxation of benefits, despite increases in the mandatory withholding rates, in order to adjust to the realities of rising costs from changing demographics.  Even before the recent two-year partial withholding “holiday,” Congress was, and is still today, discussing additional adjustments to that mandatory system.

The voluntary system should be judged as just that, a voluntary system.  As noted above, the data makes it clear that voluntary employer-based plans are, in fact, leading to a great deal of real savings accumulated to supplement Social Security.  Many in the nation work every day to encourage those savings to be increased (see www.choosetosave.org ).

The “real” questions, certainly as one reflects on the debate over the Affordable Care Act mandate, amidst today’s political and economic turmoil, are whether the Congress and the nation will be willing – and able – to pay the price of an expanded or new retirement savings mandate, and, regardless of that outcome, how can a voluntary system be moved to higher levels of success?

Notes

1 Active in this case is defined as anyone in the database with a positive account balance and a positive total contribution (employee plus employer) for 2010.

2 The RSPM was updated for a variety of significant changes, including the impacts of defined benefit plan freezes, automatic enrollment provisions for 401(k) plans, and the recent crises in the financial and housing markets. EBRI has recently updated RSPM to account for changes in financial and real estate market conditions as well as underlying demographic changes and changes in 401(k) participant behavior since January 1, 2010.  For more information on the RSPM, check out the May 2012 EBRI Notes, “Retirement Income Adequacy for Boomers and Gen Xers: Evidence from the 2012 EBRI Retirement Security Projection Model.”

Last June EBRI CEO Dallas Salisbury participated in an “Ideas in Action with Jim Glassman” program discussion with Ghilarducci and Alex Brill from the American Enterprise Institute titled “America’s Retirement Challenge: Should We Ditch 401(k) Plans?”  You can view it online here.

Single Best Answer?

By Nevin Adams, EBRI

A mainstay of multiple-choice test instruction is the admonition to select the “single best answer.”  Now, generally there really is only one valid answer, but there are times when the questions posed are sufficiently imprecise, or the potential answers insufficently specific, that more than one response is viable.  That’s where the test architect can always fall back on their notion of “best” answer– because, even if a credible argument can be made for an alternative, it’s a lot easier to grade when there’s only a single, pre-determined result.

When it comes to projecting possible outcomes in situations where there might be hundreds, perhaps thousands, or even millions of different results, it’s not uncommon to pick a single point to focus on.  For example, projections in financial analysis might use the most likely rate of claim, the most likely investment return, or the most likely rate of inflation, whereas projections in engineering analysis might use both the most likely rate and the most critical rate.  That choice provides a point estimate, one that ostensibly provides a best single estimate for purposes of analysis.

The downside of this approach, of course, is that it does not fully cover the fact that there is a whole range of possible outcomes, some more probable, some less.  The alternative, a stochastic modeling, doesn’t just pick a single likely result, but uses random variations to look at what a broad range of conditions might be like.  It does this based on a set of random outcomes, projects results, and then repeats with a new set of random variables.  In fact, this process is repeated thousands of times.

When the modeling is done, you can look at a distribution of outcomes – and with that not only consider the most likely estimate, but what ranges are reasonable as well.  It is, quite simply, a more complete and realistic assessment of potential outcomes, because, unlike so-called “deterministic” models that rely on picking a single point of experience, it includes a wide range of possibilities.

Deterministic models can predict outcomes under a few economic and demographic scenarios but don’t generally present a distribution of the wide range of scenarios that could arise from different combinations of economic and demographic variable values. Only stochastic models – like that embodied in the EBRI Retirement Security Projection Model® (RSPM) – can measure the “risk” of their performance measure values, because stochastic models, using Monte Carlo methods, are based on probability distributions.  Said another way, stochastic modeling brings into account the volatility and variability of experience that are part of living in the real world.

Those deterministic models may offer a “single” answer, but life is rarely that simple – and projections that attempt to help us make better decisions about the future needn’t be.

Notes:

  1. The EBRI Retirement Security Projection Model® (RSPM) simulates 1,000 alternative retirement paths for each household to explicitly model investment, longevity and stochastic healthcare risks (i.e., nursing home and home healthcare costs).
  2. More information on stochastic versus static/deterministic modeling can be found at http://www.actuary.org/pdf/socialsecurity/model_1005.pdf.