Five key challenges retirees face and the impact on their retirement benefits
Baby Boomers face a stark reality: They may not have enough money to retire, and they don’t know how to make that money last for their lifetime. As a result, they may run out of money in their 80s or 90s.
The possibility of running out of money is due, in large part, to the continuing shift from defined benefit (DB) pension plans to savings-based plans, such as 401(k) and 403(b) plans. Historically, DB plans, along with Social Security, provided retirement income for a large segment of the workforce. Employees had the security of a stream of pension income for life that was guaranteed by their pension plan, by their employer and ultimately by the Pension Benefit Guaranty Corporation (PBGC). In contrast, DC plans and rollover IRAs dominate today’s landscape. In 401(k) plans, plan participants typically receive a lump sum of money at retirement, roll it over into an IRA and then must figure out how to invest for retirement income and how much (or how little) to withdraw each year so that it lasts for their lifetime.
The shift from DB to DC plans has exposed retirees to a number of risks, summarized in the following five questions:
1. How much replacement income do retirees need to pay their bills, both monthly and unanticipated?
Studies suggest that retirees will need 75% to 85% of their final pre-retirement pay to live in retirement. That is more than many participants anticipate. This is primarily a savings issue, and plan sponsors can help by implementing automatic enrollment and automatic deferral increases and by offering participant retirement education and retirement income projections.
2. How long will a retiree (and perhaps a retiree’s spouse) live?
There is a substantial probability that, for a married couple, both aged 65, one or both will live 30 or more years after retirement. (The probability is 25% to 50%, depending on the study.) This obviously means that their retirement savings need to last for many years.
3. How do retirees cope with investment market downturns after they begin to withdraw from their investments?
The impact of an extended market downturn shortly before or after retirement is twofold. First, it reduces the money available to live on. Second, because the losses are fully realized as investments are liquidated to provide for living expenses, it is difficult to recover, even if the market makes substantial gains in the future.
4. How much money can retirees safely take out of their retirement savings each month?
Studies suggest that a withdrawal rate of 4% for a 65-year-old retiree’s initial account balance is “safe.” (For this purpose, “safe” means that there is at least a 90% chance that the money will last for 30 years.) Based on a survey of retirees, some people unrealistically believe they can withdraw as much as 10% each year.
5. How should retirees arrange their retirement assets to deal with impairment in their ability to make sound financial decisions as they get older?
This is an emerging issue. Cognitive ability, especially related to financial issues, degrades as people age, usually starting in their 80s. This exposes retirees to the potential for poor decisions or unprincipled or ill-advised promoters and salespeople, which can rob them of their savings at a time when they are especially vulnerable.
Viewing Retirement With a Longer Lens
American workers have longer life expectancies than prior generations, and our children may have a reasonable expectation of living to age 100 or more. This adds stress to a system that relies on plans based primarily on employee deferrals, such as 401(k) and 403(b) plans9—plans that were not designed to be the primary source of retirement income. This is not to suggest that 401(k) and 403(b) plans are flawed retirement vehicles, but instead that they need to evolve to take on a role that was not contemplated when they were created.
Unfortunately, many working Americans approach retirement without fundamental knowledge of the risks they face in a defined contribution system—some are even calling this the post-retirement crisis.10 Government regulators and the retirement plan marketplace are only beginning to understand and address the issues created by the shift to savings plans.11
To appreciate the changes that are happening, it is important to understand the problems that fuel the need for change. One change is the lengthening of retirement because of increasing life expectancies. When employees retire at age 65 or 67, they have a significant chance of living 20, 25 or even 30 more years. This means that retirees need to save more money than was needed in prior generations—because the money must last longer.12 It also means, as studies have shown, that most Americans are not saving enough to meet their retirement needs.13
Participant awareness of the retirement dilemma has also increased, with a majority saying that they need help with these issues. The findings of a participant research study14 indicate retirement security has increased in importance over the last three years for almost 90% of all participants—and more so for participants over age 50. Most mid-career participants have indicated that their DC plan will be the primary source for their retirement income.
As these studies and surveys indicate, 401(k) and 403(b) participants need help in figuring out how much to save during their working years, how to invest their savings both before and after retirement, and how to withdraw their savings in retirement.
Identifying the Risks Facing Retirees
There is a combination of factors that, taken together, can cause retirees to run out of money at a time when they have little chance of replacing it (i.e.,in their 80s or 90s).The following delves further into the five key questions and provides suggestions that plan sponsors should consider (as fiduciaries keeping the best interest of their participants in mind) to help retirees face these challenges:
1. How Much to Save = Replacement Income Risk
The major aspect of this replacement income risk is that workers do not know how much money they need to accumulate to provide a financial foundation for adequate income in retirement. As previously mentioned, studies indicate that the amount needed to sustain a retiree’s lifestyle is between 75% and 85% of their final pre-retirement pay, including their Social Security retirement income.1 But how does a participant know the amount needed at retirement to provide that much income? And, once participants know that amount, how can they know how much to defer each pay period in order to reach that goal? There are a number of services that help answer this question through “gap analysis,” which measures the amount the participant has today against their projected need, and then gives the participant an idea of how much more they should save each pay period to reach that goal.
In addition, the Department of Labor (DOL) is working on a proposed regulation that would require that monthly income projections be included on participant statements: many providers already offer this service if plan sponsors ask for it. This should help participants grasp the concept of converting their account balances into future streams of retirement income.
2. Life Expectancy = Longevity Risk
Few participants appreciate how long they will probably live after they retire.2 The reality is that there is a 50% probability, for a married couple aged 65 years, that at least one spouse will live another 27 years after retirement and a 25% probability that one will live at least 30 years.3
Indeed, some studies suggest that the probability of living to age 95 is closer to 50%.4 In other words, there is a substantial probability that a participant who retires at 65 will need retirement funds to last for 20, 30 or 40 more years. Consider the following: If the typical worker begins their career at age 25, they will have worked for 40 years upon retiring at age 65. In that period, they will need to have paid all current expenses — providing food, shelter, transportation and entertainment for themselves (and in many cases, their family) — and will have needed to create a nest egg that may need to last for 30 years or more.
The longevity risk is compounded by the fact that there is no pooling element in DC plans — as there is in DB plans where the entire pool of assets is available to pay benefits — so that the retiree must look solely to their retirement savings, plus any employer’s contributions and Social Security, to fund retirement.
As one report stated, “An estimate of age 95 is a reasonable default, given today’s longer life expectancies.”5 The consequences of assuming a shorter life expectancy could be disastrous.
3. Dealing with Market Downturns = Sequence-of-Returns Risk
“Sequence-of-returns” refers to the order in which investment returns occur. Are the first few years after retirement considered good (positive returns) years in the stock and bond markets — or bad (negative returns) years? This risk exists when assets begin to be liquidated to provide income to the retiree in a portfolio that is depreciating in value. Losses caused by market downturns are locked in when money is withdrawn for living expenses. It is impossible to recoup the losses on the money that was withdrawn and spent, even when the market goes up again. So, for example, if a participant retired during the market downturns in the early part of 2000 or in 2007, their retirement savings would have been reduced by both the withdrawals for income and the losses in the markets, endangering the stability of their income for life. Therefore, retirees need to consider the sequence-of-returns risk and protect against it.
4. Accessing Retirement Savings = Withdrawal Rate Risk
Conventional wisdom is that a 4% withdrawal rate (4% of a retiree’s initial account balance) is “safe.” This is based on studies that show there is a 90% probability that, if retirement savings are withdrawn at a rate of about 4% per year, inflation adjusted, the withdrawals will have at least a 90% probability of lasting for 30 years.6 Other studies suggest that the rate needs to be lower than 4%.7 Regardless, the fact remains that there has been little participant education about withdrawal rates.
As a result, participants are at risk of withdrawing their funds too quickly and exhausting their retirement savings. In fact, one recent study showed that more than 33% of those interviewed had no idea how much they could safely withdraw and roughly 25% expected to be able to withdraw more than 10% of their retirement savings each year.8 Given this failure to understand sustainable withdrawal rates and the need for a disciplined approach in spending retirement savings, there may be a tendency for retirees to take withdrawals at a rate that will exhaust their savings when they are in their late 70s or in their 80s.
5. Decision-Making Deterioration = Cognitive Risk
This is a problem that is only beginning to be recognized in the context of retirement income. “Cognitive risk” is the probability that, as we age, we become more prone to dementia or other cognitive disorders.15 In the context of retirement savings, studies have shown that as people age, they experience some degree of decision-making deterioration, affecting their ability to make sound financial decisions for themselves, such as those involving investments and sustainable distribution rates.16
Retirees are more prone to suffer cognitive impairment as they reach their mid-80s.17 This suggests that difficult or complex decisions (e.g., how to invest and withdraw retirement savings so that it lasts for 25 to 30 years, while protecting against sequence-of-returns and inflation risks) should happen at or near retirement versus waiting too long. It also suggests that, where possible, retirees should select insurance products, investment vehicles or investment management services that reduce or eliminate the need to make new investment and distribution decisions at a time when they may be less capable of doing so, in order to minimize the risk of running out of funds.
The retirement community has devised a number of product and service approaches to address the risks that aging Americans face. Some are investment-based, some are annuity-based and some are a blend of both.
Managed payout and retirement income mutual funds and investment management services
These investment products and services offer a partial solution to the withdrawal rate issue,in that they provide for specific distribution amounts or a specified rate of distribution and may offer inflation protection when the stock market advances. However, they cannot guarantee that the funds will last for the retiree’s lifetime, since only an insurance company can offer such a guarantee.
Traditional and deferred annuities
Traditional annuities provide solutions for longevity, withdrawal rate and cognitive impairment risks and, in some cases, may address (or partially address) inflation risk. A perceived drawback of an annuity is that the retiree loses control of their funds; that is, the retiree is locked into the annuity arrangement and cannot withdraw additional amounts if needed. Also, when the retiree dies, the payments stop. In the case of a joint and survivor annuity, the payments would only stop at the death of the spouse, while the payments would continue until the end of the fixed period for an annuity with a fixed period guarantee.
Another approach is the deferred annuity, sometimes referred to as longevity insurance. Here, annuity payments begin, if — but only if — a retiree reaches a specified age, often 85. The premium cost for a deferred annuity is lower than for an immediate annuity, but if the retiree dies before the specified date, the benefit of the annuity is lost. Of course, there is an additional cost for the insurance guarantee.
Guaranteed Minimum Withdrawal Benefit
The blended solution is an insured Guaranteed Minimum Withdrawal Benefit (GMWB) product, where a participant’s money is invested (e.g., mutual funds) and is “wrapped” by a GMWB guarantee. At retirement, the retiree begins to take withdrawals from their account at a specified rate (for example, 5% of the highest value of the investments). The actual rate will depend on the retiree’s age and whether the guarantee also covers a spouse. If the money in the investments is fully withdrawn, the insurance company will continue to make payments at the same rate.
- Solves the longevity issue by providing a guarantee of lifetime income.
- Helps address the withdrawal rate issue by establishing a rate at which funds may be withdrawn without penalty.
- May address inflation if investments increase in value.
- May help address the cognitive risk issue by establishing a pattern of withdrawals that are put in place when the participant retires.
And, if the retiree dies before the account runs out, the balance can be left to their beneficiaries. This alternative combines the benefits, but also the costs, of annuities and mutual funds.
Plan participants face real risks as they near or enter retirement. These include concerns about how much savings are needed to retire comfortably; how long the funds will need to last; how to manage the investment and withdrawal of the money to increase the likelihood of it lasting for a lifetime; how to guard against inflation and sequence-of-returns risks; and how to protect oneself against later-life cognitive impairment. Fortunately, the retirement community has recognized that these risks exist and is taking steps to address them through education, services, investments and guaranteed products.