Measuring and defining the requirements for a safe retirement Excerpted from the Employee Benefit Research Institute (EBRI) February 2015 Issue Brief, by Jack VanDerhei, Ph.D. Reprinted with permission. Read the complete report here.
Measuring retirement security—or retirement income adequacy—is an extremely important topic. EBRI launched a major project to provide this type of measurement in the late 1990s for several states concerned whether their residents would have sufficient income when they reached retirement age.
After conducting studies for Oregon, Kansas, and Massachusetts, a national model—the EBRI Retirement Security Projection Model® (RSPM)—was developed in 2003, and in 2010 it was updated to incorporate several significant changes, including the impacts of defined benefit (DB) plan freezes, automatic enrollment provisions for 401(k) plans, and the recent crises in the financial and housing markets.1
New versions of the model have been generated on an annual basis since then to include updates for financial and real estate market performance, employee demographics, and real-world behavior of 401(k) participants (based on a database of 24 million 401(k) participants) and individual retirement account (IRA) account holders (based on a database of 20 million unique individuals).
Last year,2 EBRI published extensive analysis from the 2014 version of RSPM® that focused on the EBRI Retirement Readiness RatingsTM (RRRs)—the probability that households will not run short of money in retirement. This Issue Brief expands the earlier analysis by providing similar analysis of the Retirement Savings Shortfalls (RSS)—the size of the deficits that households are simulated to generate in retirement.
The publication starts with a brief overview of RSPM® and then presents the average 2014 RSS values broken out by age cohorts, gender and family status, and years of future eligibility for participation in defined contribution (DC) plans. Distributional analysis of the RSS values is then discussed. This is followed by an analysis of the impact of nursing home and home health care costs and longevity on RSS. The impact of modification in Social Security benefits is then analyzed and aggregate deficits are provided under three different scenarios. Conclusions are offered in the final section.
EBRI Retirement Security Projection Model®
One of the basic objectives of RSPM is to simulate the percentage of the population at risk of not having retirement income adequate to cover average expenses and uninsured health care costs (including long-term-care costs) at age 65 or older throughout retirement in specific income and age groupings.
RSPM® also provides information on the distribution of the likely number of years before those at risk run short of money, as well as the percentage of preretirement compensation they will need in terms of additional savings in order to have a 50, 70, or 90 percent probability of retirement income adequacy.
VanDerhei and Copeland (2010) describe how households are tracked through retirement age and how their retirement income/wealth is simulated for the following components:
- Social Security
- DC balances
- IRA balances
- DB annuities and/or lump-sum distributions
- Net housing equity
A household is considered to run short of money in this model if aggregate resources in retirement are not sufficient to meet average retirement expenditures, defined as a combination of deterministic expenses from the Consumer Expenditure Survey (as a function of age and income) and some health insurance and out-of-pocket, health-related expenses, plus stochastic expenses from nursing-home and home-health care (at least until the point such expenses are covered by Medicaid).
This version of the model is constructed to simulate retirement income adequacy, as noted above. Alternative versions of the model allow similar analysis for replacement rates, standard-of-living calculations, and other ad hoc thresholds. The baseline version of the model used for this analysis assumes all workers retire at age 65, that they immediately begin drawing benefits from Social Security and defined benefit plans (if any), and, to the extent that the sum of their expenses and uninsured medical expenses exceed the projected, after-tax annual income from those sources, immediately begin to withdraw money from their individual accounts (defined contribution and cash balance plans, as well as IRAs).
If there is sufficient money to pay expenses without tapping into the tax-qualified individual accounts, those balances are assumed to be invested in a non-tax-advantaged account where the investment income is taxed as ordinary income. Individual accounts are tracked until the point at which they are depleted. At that point, any net housing equity is assumed to be added to retirement savings in the form of a lump-sum distribution (not a reverse annuity mortgage (RAM)).
If all the retirement savings are exhausted and if the Social Security and defined benefit payments are not sufficient to pay expenses, the individual is designated as having run short of money at that point. The EBRI Retirement Readiness Ratings TM by age cohort for 2014 show a slight improvement from 2013.3 The primary differences between the values this year and those from 2013 reflect the changes in the market value of defined contribution and IRA assets, as well as the increase in housing values during that period.
The RRRs increase by 1.6 percentage points (from 55.1 percent to 56.7 percent) for the Early Boomers, 1.0 percentage points (from 57.5 percent to 58.5 percent) for Late Boomers, and by 0.5 percentage points (from 57.2 percent to 57.7 percent) for Generation Xers.4 Given that the primary change in RRRs from 2013 to 2014 is the above-average return in the equity markets,5 it is not surprising that the older age cohorts with larger defined contribution and IRA account balances show larger improvements.
Retirement Savings Shortfalls
While knowing the percentage of households that will be at risk for inadequate retirement income is important for public policy analysis, perhaps equally important is knowing just how large the accumulated deficits are likely to be. Figure 1 depicts Retirement Savings Shortfalls by age cohort, as well as marital status and gender, for both Baby Boomers and Gen Xers. The RSS provide information on average individual retirement income deficits.
These numbers are present values (in 2014 dollars) at age 65, and represent the additional amount that individuals will have to save by age 65 to eliminate their expected deficits in retirement (which, depending on the simulated lifepath, could be a relatively short period or could last decades). The additional savings required for those on the verge of retirement (Early Boomers) vary from $19,304 (per individual) for married households, increasing to $33,778 for single males and $62,734 for single females. Even though the present values are defined in constant dollars, the RSS values are largest for Gen Xers, largely due to the assumption that health care-related costs will increase faster than the general inflation rate.
While the RSS values in Figure 1 may appear to be relatively small considering they represent the sum of present values that may include decades of deficits, it is important to remember that less than half of the simulated lifepaths modeled are considered to be “at risk.” In other words, the average RSS values represented in Figure 1 are reduced by the inclusion of simulated retirement lifepaths that will not run short of money. Looking only at those situations where shortfalls are projected, Figure 2 shows that the values for Early Boomers vary from $71,299 (per individual) for married households, increasing to $93,576 for single males and $104,821 for single females. Similar to Figure 1, the conditional RSS values are larger for younger cohorts.
Eligibility for participation in a defined contribution plan can have a significant impact on reducing these savings shortfalls. Figure 3 provides information on the average individual retirement income deficits by the number of future years eligible for coverage in a defined contribution retirement plan for Gen Xers.
The deficit values for those assumed to have no future years of eligibility (as if they were never simulated to be employed in the future by an organization that provides access to those plans) is $78,297 per individual. That shortfall decreases substantially for those with one– nine years of future eligibility, to $52,113 and even further to $32,937 for those with 10–19 years of future eligibility. Gen Xers fortunate enough to have at least 20 years of future eligibility in those programs have their average shortfall at retirement reduced to only $16,782.
Read the complete report here.