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.

“Control” Group

By Nevin Adams, EBRI

Adams

Adams

Last week I was speaking at a conference on the West Coast when a weather pattern emerged that threatened both my connecting flight, and my arrival at home. Alerted to the potential problem, I began seeking alternatives. Eventually, I was able to reroute my connecting flight—though doing so meant a later arrival at my home airport and, based on the trajectory of the storm, that later arrival increased the likelihood of running into problems there.

I continued to check in back home during the day—trying to gauge the storm’s progress, and to (re)evaluate my alternatives. As I boarded that final leg of the trip home, I knew a couple of things: The flight was (still) departing on time, and while it wasn’t snowing at home (yet) the forecast was now for more snow, starting later. The trip home wasn’t exactly restful (despite the hour), but having done what I could to minimize the impact of the storm on my travel, having attended to the things I could control, I boarded the plane, hopeful that the combination of my new route home, the pilot’s skill, and the storm’s track would result in a satisfactory, if somewhat stressful, conclusion.

Earlier this year EBRI was approached by Money Magazine to use the EBRI Retirement Security Projection Model® (RSPM)¹ to evaluate a number of potential retirement preparation scenarios, taking into account varying levels of household income, debt, marital status, retirement plan participation, health, etc. Selected results from that analysis, published in the March issue (see “Dream Big, Act Now: Six Secrets of Retirement” online here),  showed the impact that various factors could have on the chances of running short of money in retirement.

Real as those factors are, many of life’s circumstances are completely beyond our control. However, some of the most important factors—including the decision to participate in a workplace retirement plan, or the amount we choose to save—are not. Consider a 45-year-old female worker who is currently making $50,000/year, with a current retirement savings balance of $50,000. Applying the RSPM model,² we find that if she contributes 1 percent of pay to her retirement savings each year, there is a 61 percent chance that she’ll run short of money in retirement. On the other hand, a 10 percent annual contribution rate (which could be her’s along with an employer match) reduces that probability to 38 percent, while a 15 percent annual contribution rate reduces that risk to just 1 in 4 (see chart below).

My flight home from the conference was never risk-free, even before Mother Nature decided to throw a wrench into my carefully designed itinerary. That said, having the potential problem highlighted early enough allowed me to take steps to avoid the worst of what surely would have been a very long and arduous flight home, arriving home two hours later than I had originally planned, but well ahead of my likely arrival had I stayed on my original flights.

Much of today’s retirement planning tends to focus on things over which we, as individual retirement savers, have no control—things like investment returns. Perhaps those looking for true retirement serenity might, like those who invoke the so-called “Serenity Prayer,” be better advised to seek “the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference.”

Blog.062.8Mar13.Fig

Notes

¹ RSPM grew out of a multi-year project to analyze the future economic well-being of the retired population at the state level. After conducting studies for Oregon, Kansas, and Massachusetts, a national model—the EBRI Retirement Security Projection Model® (RSPM)—was developed in 2003, and by 2010 it has been updated to incorporate several 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 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 (based on a database of 23 million 401(k) participants).More information, and a chronology of the RSPM is available online here.

² This application of the RSPM assumed stochastic returns with an average of 8.9 percent for stocks and 6.3 percent for bonds.

Impact “Ed”

By Nevin Adams, EBRI

Adams

Adams

Last month, the U.S. Senate Committee on Health, Education, Labor and Pensions (HELP) held a hearing titled “Pension Savings: Are Workers Saving Enough for Retirement?” The answer to that question is, of course, about as varied as the individual circumstances it contemplates, but certainly at a high level, the best answer is, “it depends.”

It depends on your definition of “enough,” for one thing—and it might well depend on your definition of retirement, certainly as to when retirement begins, not to mention your assumptions about saving and/or working during that period.(1) While those are individual choices (sometimes “choices” imposed on us), they can obviously make a big difference in terms of result.

For public policy purposes, EBRI has defined adequate retirement income as having the financial resources to cover basic expenses plus uninsured medical costs in retirement. Working from that definition as a starting point, along with an assumption that retirement represents the cessation of paid employment and begins at age 65, we have projected that approximately 44 percent of Baby Boomer and Gen-Xer households are simulated to be at risk of running short of money in retirement, assuming they retain any net housing equity until other financial resources are depleted. That’s a lot of households, to be sure, but as an EBRI report noted last year, it includes a wide range of personal circumstances, from individuals projected to run short by as little as a dollar to those projected to fall short by tens of thousands of dollars.(2)

However, the focus of the recent Senate HELP hearing quickly turned from an acknowledgement that many workers aren’t saving enough to what to do about it. In a recent response to questions posed at the hearing,(3) EBRI Research Director Jack VanDerhei compiled a list of alternatives that EBRI research has modeled in recent years, some mentioned at the hearing, along with the impact each is projected to have on that cumulative savings shortfall.

Specifically, the impacts quantified on retirement readiness included in EBRI’s response were:

  • The availability of defined benefit (pension) plans.
  • Future eligibility for a defined contribution (401(k)-type) plan.
  • Increasing the 401(k) default deferral rate to 6 percent.
  • Job changes and default deferral rate restarts.
  • 401(k0 Loans and pre-retirement withdrawals.

The impacts of these factors vary, of course. Consider that, overall, the presence of a defined benefit accrual at age 65 reduces the “at-risk” percentage by about 12 percentage points. On the other hand, merely being eligible for participation in a DC plan makes a big difference as well: Gen Xers with no future years of DC plan eligibility would run short of money in retirement 60.7 percent of the time, whereas fewer than 1 in 5 (18.2 percent) of those with 20 or more years of future eligibility are simulated to run short of money in retirement.(4)

Ultimately, if you’re looking to solve a problem, it helps to know what problem you’re trying to solve. And you don’t just want to know that a solution will make a difference, you want to know how much of a difference that solution will make.

Notes

(1) Many other projections overlook, implicitly or explicitly, uninsured medical costs in retirement, and many simply publish a projected average result that will be correct only 50 percent of the time, without acknowledging these limitations. Moreover, while various estimates have been put forth for the aggregate retirement income deficit number, when taking into account current Social Security retirement benefits and the assumption that net housing equity is utilized “as needed,” as well as uninsured health care costs, the EBRI Retirement Security Projection Model (RSPM) indicates the aggregate national retirement income deficit to be $4.3 trillion for all Baby Boomers and Gen.

(2) Nearly one-half (49.1 percent) of Gen Xers are projected to have at least 20 percent more than is simulated to be needed, for example, while about 1 in 5 (19.4 percent) are projected to have less than 80 percent of what is needed. See “All or Nothing? An Expanded Perspective on Retirement Readiness,” online here.

(3) The EBRI response to the Senate HELP hearing questions is available online here.

(4) See “Retirement Income Adequacy for Boomers and Gen Xers: Evidence from the 2012 EBRI Retirement Security Projection Model,” online here.

Tax Incentives for Retirement Plans: Lessons from Denmark?

Notes.Jan13.FinalFlow.TxIncns.Pg1A recent study found that tax incentives for retirement savings in Denmark had virtually no impact on increasing total savings But are those findings relevant to the United States?

Maybe not, according to a new report by EBRI: The two retirement systems have some similarities but also major differences—mainly that, unlike in the United States, in Denmark the availability of employment-based, tax-deferred retirement plans is not tied to the tax-deferred status of the accounts.

At issue are so-called “tax expenditures” in the United States—preferential tax treatment for public policy goals such as retirement, health insurance, home ownership, and a variety of other issues—that currently are under heavy scrutiny in the debate over the federal debt, taxes, and spending.

The authors of the study on Danish savings behaviors offered statistical evidence that changes in tax preferences for Danish work place retirement savings plans had virtually no effect on total savings of those affected by the change. This has drawn the attention of those interested in considering a modification of the long-standing tax preferences for employment-based retirement savings plans in this country.

However, aside from the differences in incentive structures between the two countries, the EBRI report notes that study of Danish workers examined only the impact that changes in tax incentives for work place retirement plans might have on worker savings behaviors—but did not address how employers might react to changes in retirement savings tax incentives.

The EBRI report notes recent surveys have found many American private-sector plan sponsors have expressed a desire to offer no plans at all in the absence of tax incentives for workers. If this happened, low-wage workers—who are generally less prepared for retirement—would suffer on several counts, said Sudipto Banerjee, EBRI research associate and co-author of the report.

“The Danish study provided insight into the savings behavior of Danes, conditioned by the culture and influences of public policies and programs of Denmark,” Banerjee said. “But the ‘success’ of work place retirement plans in the United States depends on the behavior of two parties: workers who voluntarily elect to defer compensation, and employers that sponsor and, in many cases, contribute to them.”

“While the study of Danish savings behaviors presented the impact of tax-incentives and the ‘nudges’ of automatic mandatory savings as an ‘either/or’ solution, the optimal solution—certainly for a voluntary system such as the one currently in place in the U.S.—may well be a combination of the two,” noted Nevin Adams, co-director of the EBRI Center for Research on Retirement Income, and co-author of the report.

The full report is published in the January 2013 EBRI Notes, “Tax Preferences and Mandates: Is the Danish Savings Experience Relevant to America?” online at www.ebri.org

“Breaching” Out?

By Nevin Adams, EBRI

Adams

Adams

“401(k) breaches undermining retirement security for millions,” was the headline of a recent article in the Washington Post.(1) No, we’re not talking about some kind of data hacking scandal, nor some new identity theft breach. Rather, those “breaches” are loans and withdrawals from 401(k)s.

Providing the impetus for the article is a new report by HelloWallet(2) that indicates that “more than one in four workers dip into retirement funds to pay their mortgages, credit card debt or other bills.”

While the article primarily deals with the potentially negative aspects of loans and withdrawals, it also touches on some broader concerns—and does so with some factual inaccuracies. For example, the article incorrectly states that “in 1980, four out of five private-sector workers were covered by traditional pensions;” in fact, only about half that many actually were at that point (a correct statement would be that 4 out of 5 covered by a plan at that time were in a traditional pension, which works out to about 2 in 5 of all private-sector workers—which puts the article’s “now, just one in five workers has a pension” statement in a far more accurate context).

The article notes that the “most common way Americans tap their retirement funds is through loans,” although U.S. Department of Labor data indicate that loan amounts tend to be a negligible portion of plan assets and that very little is converted into deemed distributions in any given year. That finding is supported by hard data from the EBRI/ICI 401(k) database, the largest micro-database of its kind: Among participants with outstanding 401(k) loans in the EBRI/ICI database at the end of 2011, the average unpaid balance was $7,027, while the median loan balance outstanding was $3,785.(3) The Washington Post article cautions that these loans “must be repaid with interest,” but fails to mention that the 401(k) participant is paying interest to his/her own account: Those repayments represent a restoration of the retirement account balance by the participant, as well as a return on that investment. Sure, that interest payment is coming from the participant’s own pocket, but it’s generally being deposited into their own retirement account, and (if it was being used to pay down debt) likely at a much more favorable rate of interest.

The article also notes that those who withdraw money from their 401(k) early (before the authorized age) face “hefty” penalties, and certainly there is a financial price. However, those penalties consist of the 10 percent early withdrawal penalty (that was put in place long ago to discourage casual withdrawals by those under age 59 -½), and the income taxes they would be expected to pay on the receipt of money on which they had not yet paid taxes (which they would likely pay eventually).(4)

The HelloWallet report describes defined contribution (DC) retirement plans as a “marginal contributor to the actual retirement needs of U.S. workers.” However, an EBRI analysis of the Federal Reserve’s Survey of Consumer Finance (SCF) data, looking at workers who are already retired, finds that DC balances plus IRAs—which for many retired individuals were funded by rollovers from their DC/401(k) plans when they left work—represent nearly 15 percent of their total assets (which includes things like houses, but does not include Social Security and defined benefit annuity payments, although DB rollovers are included), and nearly a third of their total financial assets, as defined in the SCF.

The dictionary describes a “breach” as an “infraction or violation of a law, obligation, tie, or standard.” The article quotes the HelloWallet author as noting that “What you have is 401(k) participants voting with their wallets saying they would much rather use this money for other purposes.” However, these reports can’t always know, and thus don’t consider, how many participants and their families have been spared true financial hardship in the “here-and-now” by virtue of access to funds they set aside in these programs(5) (an AonHewitt study,(6) cited both in the article and in the HelloWallet report, notes that just over half of the hardship withdrawal requests were to avoid home eviction or foreclosure).

It’s hard to know how many of these “breachers” would have committed to saving at the amounts they chose, or to saving at all, if they (particularly the young with decades to go until retirement) had to balance that choice against a realization that the funds they set aside now would be unavailable until retirement. We don’t know that individuals who chose to save in their 401(k) plan did so specifically for retirement, rather than for interim (but important) savings goals—such as home ownership or college tuition—that, sooner or later, make their own contributions to retirement security. Indeed, what appears to a be a short-term decision that might adversely affect retirement preparation may actually be a long-term decision to enhance retirement security with a mortgage paid off or higher earnings potential.

In sum, we don’t know that these decisions represent a “breach” of retirement security—or a down payment.

Notes

(1) The Washington Post article is online here. 

(2) You can request a copy of the HelloWallet report here.

(3) For an updated report on participant loan activity from the EBRI/ICI database, see “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2011,” online here. 

(4) While the Post article states that these taxes would be paid at capital gains rates, in fact, withdrawals are taxed as ordinary income.

(5) See “’Premature’ Conclusions,” online here. 

(6) See “Leakage of Participants’ DC Assets: How Loans, Withdrawals, and Cashouts Are Eroding Retirement Income 2011,” 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

Making a “List”

By Nevin Adams, EBRI

Adams

Adams

Years agowhen my kids were still kidswe discovered an ingenious Web site1 that purported to offer a real-time assessment of your “naughty or nice” status.

As parents, we rarely invoked the name of Santa to encourage good behavior, and for the very most part our children didn’t require much “redirection.”  But no tone of voice or physical threat ever had the impact of that Web siteif not on their behaviors (they were kids, after all), then certainly on the level of their concern about the consequences.  In fact, in one of his final years as a “believer,” my son (who, it must be acknowledged, had been PARTICULARLY naughty that December) was on the verge of tears, worried that he’d find nothing under the Christmas tree but the coal and the bundle of switches he surely deserved. 

One could argue that many participants still act as though some kind of benevolent elf will drop down their chimney with a bag full of cold cash from the North Pole, that somehow, their bad savings behaviors throughout the year(s) notwithstanding, they’ll be able to pull the wool over the eyes of a myopic, portly gentleman in a red snow suit.

Next month we’ll field the 23rd annual version of the Retirement Confidence Survey,2 where we will, among other things, seek to gain a sense of American workers’ preparation for (and confidence about) retirement, as well as some idea as to how those already retired view the adequacy of their own preparations.  In previous years we’ve seen confidence wax stronger and then waneand we’ve seen distressingly low levels of preparation that sometimes seem at odds with the high confidence expressed.  However, in wake of the Great Recession, we’ve also seen a growing awareness of the need for those preparations,3 and cognizance of the challenge in doing so.  We’ve also seen regrets that more wasn’t done earlier, at a time when the options were greater, and time an asset.  

Ultimately, the volume of presents under our Christmas tree never really had anything to do with our kids’ behavior. As parents, we nurtured their belief in Santa Claus as long as we thought we could (without subjecting them to the ridicule of their classmates), not because we expected it to modify their behavior (though we hoped, from time to time), but because kids should have a chance to believe, if only for a little while, in those kinds of possibilities.

We all live in a world of possibilities, of course. But as adults we realize—or should realize—that those possibilities are frequently bounded in by the reality of our behaviors.

Yes, Virginia, there is a Santa Claus—but he looks a lot like you, assisted by “helpers” like the employer match, tax incentives, automatic enrollment and deferral increases, and qualified default investment alternatives.

Notes

(1) The Naughty or Nice site is STILL online, here.

(2) More information about the Retirement Confidence Survey, as well as results from prior years, is available online here.

(3) That first step on that path, and it’s a critical one, is to Choose to Save.®  A great place to start those preparations figuring out quickly what you’ll need is the BallparkE$timate,® available online here.  Organizations interested in building/reinforcing a workplace savings campaign can find free resources—and a handy schedule of events around which to construct a program—courtesy of the American Savings Education Council (ASEC).  Choose to Save® is sponsored by the nonprofit, nonpartisan Employee Benefit Research Institute Education and Research Fund (EBRI-ERF) and one of its programs, the American Savings Education Council (ASEC). The Website and materials development have been underwritten through generous grants and additional support from EBRI Members and ASEC Partner institutions.

Retirement Readiness: Who’s Close and Who’s Not

Jack VanDerhei

Among those who are likely to miss their retirement savings goal, how many will be close? And how many will miss it by a mile?

According to a new report by EBRI, nearly half of Generation X households will have enough to cover basic retirement costs, and about a third will fall short—but not by much. About 20 percent are likely to be far off-target.

Past analysis using EBRI’s proprietary Retirement Security Projection Model® (RSPM) has found that roughly 44 percent of Baby Boomer and Gen X households are projected to be at-risk of running short of money in retirement, assuming they retire at age 65 and retain any net housing equity in retirement until other financial resources are depleted. However, that includes a wide range of personal circumstances, from individuals projected to run short by as little as a dollar to those projected to fall short by tens of thousands of dollars.

EBRI’s new research takes a closer look at where different types of people are likely to fall within the range of retirement income adequacy. Looking specifically at Gen X households (those born between 1965–1978, currently ages 34–47), EBRI’s RSPM analysis finds that:

  • Nearly one-half (49.1 percent) will have substantially more (at least 20 percent more) than the income threshold deemed adequate to afford basic retirement expenses and uninsured health care costs.
  •  Approximately one-third (31.4 percent) will be close to the threshold for retirement adequacy (between 80–120 percent of the financial resources necessary to cover basic retirement expenses and uninsured health care costs.
  • About 1 in 5 (19.4 percent) are projected to be substantially below (less than 80 percent) of what is needed.

EBRI also finds that a worker’s future years of eligibility in a defined contribution retirement plan makes a huge difference in his or her likelihood of having enough money to cover basic retirement expenses and uninsured health care costs. Among Gen Xer single females simulated to have no future years of defined-contribution-plan eligibility, nearly two-fifths (39 percent) are in the most vulnerable (less than 80 percent) category, although this shrinks to only 8 percent for those with 20 or more years of future eligibility in a defined contribution plan.

“One problem with simply classifying a household as ‘at risk’ or not is that some households may be missing the threshold by relatively small amounts,” said Jack VanDerhei, EBRI research director and author of the report. “Using this new classification to analyze the impact of future eligibility in a defined contribution plan on the percentage of households with less than 80 percent of the necessary resources for sufficiency shows a substantial impact for all family/gender categories, especially single females.”

Full results are published in the November 2012 EBRI Notes, “All or Nothing? An Expanded Perspective on Retirement Readiness,” online at www.ebri.org

Predict-Able

By Nevin Adams, EBRI

Retirement planning is a complex and highly individualized process, but many people find it easier to start by focusing on a single, specific target number.

For those interested in a single number for health care expenses in retirement, a recent EBRI report provides that.  Among other things, the report noted that a 65-year-old man would need $70,000 in savings and a woman would need $93,000 in 2012 if each had a goal of having a 50 percent chance of having enough money saved to cover their projected health care expenses in retirement.  A 65-year-old couple, both with median drug expenses, would need $163,000 in 2012 to have a 50 percent chance of having enough money to cover health care expenses.1

Determining how much money is needed to cover health care expenses in retirement is complicated.  It depends on retirement age, the length of life after retirement, the availability and source of health insurance coverage after retirement to supplement Medicare, the rate at which health care costs increase, interest rates, market returns, and health status, among other things.  That said, it is possible to project health care expenses with some accuracy, and EBRI’s recent analysis uses a Monte Carlo simulation model to estimate the amount of savings needed to cover health insurance premiums and out-of-pocket health care expenses in retirement.

However, those recent “single number” projections specifically excluded the financial impact of long-term care.

EBRI has long acknowledged the critical impact that health care expenses can have on retirement finances, and considering that EBRI has long incorporated both the costs of health care and long-term care in its Retirement Savings Projection Model® (RSPM), one might well wonder why this particular report specifically excluded those long-term care projections.

For all the complexity in those calculations, the reality is that everyone won’t have to deal with the expenses associated with long-term care.  For those who will, the impact on retirement finances could be significant, even catastrophic.2  That’s why EBRI has modeled their impact in the RSPM since 2003.

As noted above, for those interested in a single number, the recent EBRI report provides that, along with variations that permit one to take into account different likelihoods of success and gender/marital combinations.  We are able to do that because we treat longevity risk and investment risk stochastically,3 and the fact that those expenses (and the costs of insurance) are, at least relatively, predictable.

But while it is possible to come up with a single number that individuals can use to start setting retirement-savings goals, it is important to bear in mind that a single number based on averages will be wrong for the vast majority of the population—and that those who rely exclusively on that single number run the risk of running short.

Notes

1 Unlike reports produced by a number of organizations, the EBRI report also provided estimates for those interested in a better-than-50-percent chance of success.  See ”Savings Needed for Health Expenses for People Eligible for Medicare: Some Rare Good News,” online here.

2 The EBRI Notes article above illustrates the difference: If you ignore the impact of nursing home and home health care expenses, more than 90 percent of single male Gen Xers were projected to have no financial shortfall in retirement—but when that impact was included, just 68 percent of that group was projected to have no financial shortfall in retirement.  The error of ignoring nursing home and home health care costs is even more profound if one focuses on the percentage of individuals with shortfalls in excess of $100,000. 

3 For an expanded description of the difference stochastic modeling can make, see “Single Best Answer.”

See also:  “Employment-Based Retiree Health Benefits: Trends in Access and Coverage, 1997-2010”, and “Effects of Nursing Home Stays on Household Portfolios.”

A Moving Target

By Nevin Adams, EBRI

Adams

Trying to figure out how much money an individual or couple needs to live on in retirement is, to put it mildly, a complicated business. Among other factors, it depends on the age at which he or she retires, where they live, and how they live. It can be affected by marital status, their health, and the markets, both before and after retirement.

And, as a recent EBRI Notes article (see “Savings Needed for Health Expenses for People Eligible for Medicare: Some Rare Good News”)  explains, it can also be affected by the availability and source of health insurance coverage after retirement to supplement Medicare, and the rate at which health care costs increase.

Additionally, public policy that changes any of the above factors will also affect spending on health care in retirement. Consequently, trying to hit that target can feel like aiming at a bulls-eye that is not only moving, but moving fast, and zig-zagging away from the bouncing, moving vehicle in which you find yourself.

We’re often asked to come up with a single number that individuals can use to set their retirement savings goals—and while it’s certainly possible to do so (and others have), what’s often glossed over is that while that approach appears to offer clarity, a single number based on averages will be wrong for the vast majority of the population.¹ Moreover, frequently overlooked in the generalizations about retirement spending levels is the very real (and potentially huge) financial impact of post-retirement health care expenses.

Individuals will be responsible for saving for health insurance premiums and out-of-pocket expenses in retirement for a number of reasons. Medicare generally covers only about 60 percent of the cost of health care services for Medicare beneficiaries ages 65 and older, while out-of-pocket spending accounts for 13 percent. The percentage of employers offering retiree health benefits has been falling, even in the public sector, and even when offered, those benefits are becoming less generous and more expensive to the retiree.

Using a simulation model, we recently estimated the amount of savings needed to cover health insurance premiums and out-of-pocket health care expenses (excluding long-term care) in retirement. The EBRI article presents estimates for people who supplement Medicare with a combination of individual health insurance through Plan F Medigap coverage and Medicare Part D for outpatient-prescription-drug coverage. For each source of supplemental coverage, the model simulates 100,000 observations to allow for the uncertainty related to individual mortality and rates of return on assets in retirement, and computes the present value of the savings needed to cover health insurance premiums and out-of-pocket expenses in retirement at age 65. From those observations, the analysis determined asset targets for having adequate savings to cover retiree health costs 50 percent, 75 percent, and 90 percent of the time, both for individuals,² and for a stylized couple, both of whom are assumed to retire simultaneously at age 65.³

Of course, some will need more money than the amounts cited in the report, which did not factor in the savings needed to cover long-term care expenses, nor the reality that many individuals retire prior to becoming eligible for Medicare. Some will need to save less than projected if they choose to work during retirement.

Still, as hard as it can be to hit a moving target, it’s even harder to hit a target you can’t see.

Notes

¹ For more on the shortcomings of this approach, see “Single Best Answer.”

² Separate estimates are presented for men, women, and married couples. Because women have longer life expectancies than men, women will generally have larger expenses than men to cover health insurance premiums and health care expenses in retirement, regardless of the savings target.

³ Our analysis found a 1–2 percent reduction in needed savings among individuals with median drug use and 4-5 percent reductions in needed savings among individuals at the 90th percentile in drug use since EBRI’s 2011 analysis (see “Savings Needed for Health Expenses for People Eligible for Medicare: Some Rare Good News”).