Risk In Retirement

What Moves the Retirement Readiness Needle?

Quantification of Risk and Evaluation of New Proposals

by Stephen Blakely

Mr. Blakely is affiliated with the Employee Benefit Research Institute (ebri.org). Following is an excerpt from his April 2016 paper. Read the entire repot here. Reprinted with permission.

With the United States facing an estimated national retirement savings shortfall of $4.13 trillion,1 how can more Americans be brought into a retirement savings plan, and how can they be persuaded to save enough to cover simulated costs in retirement?

Those questions were explored by a panel of retirement experts at EBRI’s 77th policy forum, focusing on policy proposals aimed at increasing private-sector retirement plan coverage and possible improvements to retirement plan designs by sponsors of retirement plans.

The session also included a short presentation of the demographic forces in the United States that underpin the issue, in particular the fact that more Americans than ever are living longer, will spend more time in retirement, and face the potential crisis of outliving their savings.

About a hundred people attended the EBRI event, held Dec. 10, 2015, in Washington DC, on the topic: “What Moves the Retirement Readiness Needle: Quantification of Risk and Evaluation of New Proposals.”

Post-Retirement Risk

Jack VanDerhei, EBRI research director, noted that EBRI research has already extensively analyzed post-retirement risks, such as longevity, long-term care, and investment risk.

He then reviewed research dealing with pre-retirement risks and the likely impact of new proposals to mitigate their impact, including :

  • (1) ways to increase the number of employees offered some type of retirement savings option,
  • (2) leakages from the defined contribution system,
  • (3) modifying the employer incentives to increase employee contributions to higher levels, and
  • (4) what happens when the equity market turns down and investment returns suffer.

VanDerhei summarized the EBRI Retirement Security Projection Model®2 and provided baseline estimates of retirement income adequacy for Boomer and Gen Xer households.

He noted that quantifying retirement income adequacy depends on several key factors, including how “adequacy” is defined, and whether or not long-term care costs are included in the calculations:

  • • If ‘adequacy’ is defined as being able to cover 100 percent of the average expenses in retirement,including long-term care costs, then about 57.6 percent of all Baby Boomers and Gen Xer households would be adequately prepared for retirement.
  • • If ‘adequacy’ is pegged at 90 percent of average costs in retirement, about 68 percent would be adequately prepared.
  •  If ‘adequacy’ is 80 percent of the average costs,about 82 percent would be adequately prepared.

He noted that if long-term care costs are ignored, the chances of achieving retirement income adequacy are significantly higher. Specifically, 75.5 percent of all Baby Boomers and Gen Xer households would be adequately prepared for retirement if “adequacy” is defined as being able to cover 100 percent of the average expenses in retirement, but long-term care costs are excluded.

If adequacy is based on 90 percent of average costs in retirement without long-term care costs, the value increases to 82.6 percent. With an 80 percent average cost threshold without long-term care costs, 90.9 percent of the households would be adequately prepared.

Automatic IRAs

Concerning efforts to expand private-sector retirement plan coverage, VanDerhei noted that the impact of proposed “automatic IRAs” for all workers currently ages 35-64 depends heavily on the required level of contributions and “opt- out” rates—how many workers refuse to participate. Under one scenario (total participation/no opt-outs and a 3 per- cent of pay contribution rate), he said that auto-IRAs would reduce projected retirement savings deficits by 6.5 per- cent.

By comparison, if employers that do not currently offer any kind of retirement plan instead offered a 401(k) plan similar to what other employers of the same size offer, there would a significantly higher reduction in retirement savings deficits—19.4 percent, VanDerhei said. Those projections are based on empirical opt-out rates in the private sector as well as actual employee contribution rates, asset allocation, account balances and employer contribution formulae (both matching and nonelective).3

more than a quarter (27.3 percent) of those in the lowest income quartile would miss hitting the 80 percent threshold of pre-retirement income replacement because of the combined sources of leakage

The advantages of a universal DC-type plan are also sharply evident when examined by age. Modeling the youngest workers (ages 35‒39) under the same scenario used above (no opt-outs, 3 percent contribution rate), an auto-IRA would reduce retirement savings shortfalls by 10.6 percent—compared with 28.2 per-cent for a universal DC plan with workers of the same age.

These reductions will decrease for older workers. For example, an auto-IRA would decrease Retirement Savings Shortfalls (RSS) by 9.9 percent for those 40-44, while the universal defined contribution plan would reduce RSS by 25.9 percent in that age cohort.

For those 45-49 the reductions would be 7.9 percent for the auto-IRA and 22.1 percent for the universal defined contribution plan. For those already 50-54 the auto-IRA would reduce RSS by 5.1 percent while the universal defined contribution plan is simulated to have a 15.5 percent reduction.

The Leakage-Risk

VanDerhei also addressed the “leakage” risk—workers who take money out of their retirement savings plans, either by taking a loan from their 401(k) account and not repaying it, taking a hardship withdrawal, and/or spending the money in their accounts at job change rather than rolling it over into another savings plan .

VanDerhei’s analysis finds that the effect of retirement plan leakages varies by income and type of leakage, but that clearly the lowest-income quartile is most adversely affected (the population simulated consists of workers currently ages 25–29 who will have more than 30 years of simulated eligibility for participation in a 401(k) plan).

Among the lowest-income quartile, 4.2 percent would have achieved an 80 percent inflation-adjusted replacement rate by combining 401(k) accounts (and any IRA rollovers originating with 401(k) plans) and Social Security benefits but miss doing so because of leakages due to defaulting on a 401(k) loan; 8 percent miss it because of hardship withdrawals with a required six-month suspension of contributions; and 20 percent miss it because of cashing out their accounts at job change and not rolling them over.

Overall, more than a quarter (27.3 percent) of those in the lowest income quartile would miss hitting the 80 percent threshold of pre-retirement income replacement because of the combined sources of leakage, VanDerhei said.

VanDerhei also noted the dilemma facing retirement plan sponsors: Closing off all leakage by prohibiting cash-outs, hardship withdrawals or 401(k) loans would result in some low-income workers reducing their contributions or not participating in the plan at all—which would make their lack of savings even worse. “If you take away cash out, if you take away loans, and if you take away hardship withdrawals, you’re likely to decrease participation and certainly decrease contributions on the part of many of the participants, especially the low income,” he said.

Concerning the so-called “stretch match” designed to get workers to contribute more to their 401(k) by expanding the percentage of compensation that is eligible for an employer matching contribution, 4 VanDerhei said any advantages depend heavily on how a stretch match is structured.

Generally, higher-income workers would do better than lower- income workers under a stretch match, he noted, but in the scenario in which employers as much under the stretch match proposal as they would have under the PPA safe harbor, a move to the stretch match proposal simulated in the model could increase 401(k) contributions by 6.7 percent for low-income workers to 7.9 percent by high-income workers.

Finally, VanDerhei also ran analysis of how much of an impact a decrease in market rates of return are likely to have, using for comparison the sharp drop in equities in August 2015, when equity returns dropped 4.3 percent and fixed- income returns dropped 1.3 percent.

Read the entire report here.


The Employee Benefit Research Institute is a private, nonpartisan, nonprofit research institute based in Washington, DC, that focuses on health, savings, retirement, and economic security issues. EBRI does not lobby and does not take policy positions. The work of EBRI is made possible by funding from its members and sponsors, which include a broad range of public, private, for-profit and nonprofit organizations. For more information go to www.ebri.org