Retirement on Two Wheels

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Remember the "three-legged stool" of retirement security that was once supported by Social Security, private pensions, and personal savings? With the demise of pensions we're down to two. There's no such thing as a two-legged stool, of course. So instead we're tempted to think of modern retirement planning as a bicycle.

With only two supports the new retirement vehicle is a bit tippy. If you suddenly change direction, or hit a big enough pothole, or some important part breaks, you're likely to wake up on the side of the road. But as long as your strategy is well constructed and regularly maintained, most people should find it stays solidly upright - as long as you keep pedaling.

This is essentially the finding of a new EBRI study discussed here. The study asks if a combination of Social Security and 401(k) will sustain most workers adequately in retirement. We're glad to report the short answer is a qualified "yes."

The Big Question
We like this project in part because of its big-picture focus on "retirement adequacy." Using a massive database and proprietary modeling techniques (more details are here), EBRI seeks to answer for the nation the same question we do for our customers: Will I have enough income when I retire?

The apparent good news: if all goes to plan, between 83% and 86% of workers with continuous access to a 401(k) plan are expected to replace at least 60% of their age-64 income in retirement. If the threshold is increased to 70% income replacement, 73% to 76% will still meet it. At a more realistic 80% the numbers continue to fall off, though less sharply for those in the lowest-income quartile.

Some Big Assumptions
Any economics student will tell you to examine the assumptions. One stands out: the study assumes 30 years of eligibility for a 401(k). We wish everyone enjoyed such access, but the truth is only about 60% of today's employers offer a plan at all, and not every employee maintains an unbroken work history.

Note that the study only assumes eligibility. Rather than making things easier by only looking at workers who choose to participate, the projections model participation and contribution rates as part of the simulation. Knowing this makes the results quite a bit more optimistic. And speaking of which, when the study changes the model so that that all plans feature auto-enrollment and auto-escalation, the numbers jump dramatically, sometimes by double digits.

The other big assumption is that Social Security benefits will continue forever without significant changes. EBRI alternately simulates a 24% cut in benefits beginning in 2033, when (by one calculation) the money may run out, and the results are predictably severe. Our young economist might caution that this is a policy issue, not an economic one. Either way the long term impacts of these issues are staggering.

From Here to There?
Finally, there's another important assumption that is not spelled out as clearly. In fact, it's rarely addressed adequately in any such analysis: how exactly do retirement assets become retirement income?

According to a footnote, EBRI actually uses two methods, for two separate projections. For the headline calculations about whether 401(k) plus Social Security can deliver adequate income, it's assumed that 100% of every balance is used to purchase an annuity at age 65. To calculate whether retirees will run out of money in their lifetime, however, the authors use a steady draw-down instead.

We believe the income side of the equation deserves far more consideration. The Social Security element is transparent and predictable (until, perhaps, it isn't). But although it's relatively straightforward to plan for, even some professional financial advisors don't grasp the nuances around when to begin taking payments. One observer argues further that many fail to properly consider the benefit "an income-generating bond asset class, which could allow the client to be more aggressive with their other assets."

In contrast, most people have no clue how best to turn 401(k) assets into income, much less how to maximize the lifetime income they produce. Getting this right shouldn't be guesswork, though considering actuarial and market uncertainties it's an imperfect science. Our own research shows that by optimizing income in the same way we do investments, using a similar methodology, retirees can enjoy a substantial boost in outcomes.

Room for Improvement
If everyone had access to a tool like GuidedSpending for optimizing income as well as a best-practice 401(k), we'd expect EBRI's numbers to look even more impressive. Moreover, squeezing the greatest income from each dollar of assets is even more important for those individuals who, for whatever reason, come to the table with less-than-adequate account balances. While income management can't entirely make up for a lack of savings, it can certainly help.

While on the surface the report offers good news, we think it could be a lot better. We look forward to the day when best-practice retirement planning is built to keep rolling all the way through retirement.

Are these results cause for real optimism, or just a better way of framing a bad situation? As always, your comments are welcome.