The New Savings Paradigm

Baby Boom retirees rely more than ever on personal savings to sustain retirement income

By Christopher J. Cummings and Shawn E. Sanderson

Mr. Sanderson is an Investment Consultant with Manning & Napier. His primary responsibilities include contributing to the firm’s Life Cycle consulting efforts.
Mr. Cummings, CFP, CFA is the Managing Director of the Client Analytics Group at Manning & Napier. In this capacity, he is responsible for addressing client problems related to objectives setting, asset allocation, portfolio analysis, and manager selection and monitoring.  Inquiries to either authors should be sent to [email protected]

As the number of employers offering a defined-benefit pension continues to decrease, the primary responsibility for saving and planning for retirement has shifted toward the individual. At the same time, potential and current retirees are becoming increasingly concerned about the future of Social Security and Medicare, likely influencing important decisions, such as when to begin taking Social Security benefits. The probable result is that retiring workers will continue to increasingly rely on defined contribution accounts (such as 401(k)s) and personal savings to generate a sustainable income stream throughout retirement. With this increase in individual responsibility, paired with today’s unusually uncertain economic and market environment, retirees should consider the following financial risks and challenges as they prepare for retirement:

  • Equity markets have been volatile, leaving retiring workers fearful and uncertain about their financial future. A severe market downturn early in retirement can drastically reduce a nest egg, forcing retirees to make tough decisions, such as substantially lowering their standards of living. Likewise, reacting emotionally to market volatility can result in hasty investment decisions that could compromise retirement security.
  • Many investors have recently flocked toward “safe” havens, such as U.S. Treasuries, reducing their yields. As a result, these securities cannot generate the level of income required to meet day-to-day spending needs of retirees. In fact, yields on traditional “safe,” income-producing securities, like U.S. Treasuries, are negative in some cases on an inflation-adjusted basis.
  • Health care costs continue to rise faster than general inflation. This trend is particularly troubling for retirees’ since health care related costs often represent a growing portion of overall spending as they age. According to the Employee Benefit Research Institute (EBRI), a 65-year-old couple in 2011 with median drug expenses would need approximately $166,000 to have a 50% chance of meeting their medical expenses throughout retirement and approximately $244,000 to have a 90% chance.
  • Inflation can drastically reduce the purchasing power of a retirement portfolio over time. Assuming average annual inflation rate of 3%, prices double approximately every 25 years.
  • Medical advances are helping people live longer. For a married couple at 65 years old, there is a 50% chance that at least one of the spouses will live to just about age 90. Continued increases in life expectancy require individuals to generate larger retirement balances than they may have initially planned or risk outliving available assets, also known as longevity risk.

With just a cursory assessment of the retirement landscape, the increasing level of uncertainty facing retirees becomes apparent. As waves of baby boomers retire with more personal responsibility for their retirement preparedness than previous generations, demand for ways to convert retirement assets into sustainable income continues to increase.

This conversion is often easier said than done. The majority of retirees face the challenge of striking the right balance between capital growth and capital preservation in their retirement portfolios. The investment industry has responded with a variety of long-standing and fresh solutions to help address what could be described, for many, as a retirement crisis.

  • Annuity products, with varying levels of sophistication, have long been used as part of retirement strategies. Immediate annuities have gained popularity among retirees, providing a predictable stream of payments over a lifetime in exchange for an initial lump sum investment. In addition, retirees have access to a variety of add on annuity features such as coverage for long-term care benefits, inflation-adjusted payouts, and guaranteed-living benefits, or GLBs. While GLBs come in a variety of designs, the features generally provide individuals with a guaranteed lifetime payout that can potentially increase, but typically will not decrease, based on the performance of underlying investments. Therefore, retirees that invest in GLB-based products generally retain the longevity risk protection associated with annuities but may also benefit from rising capital markets, through increased payout streams. Additional features or guarantees added to annuity products are typically subject to additional costs, which may reduce their appeal for some retirees.
  • Retirement target products, now commonly included as investment options on defined contribution plan menus, have continued to evolve, with any eye toward maximizing participant outcomes. In the past few years, many target date providers have focused their efforts on addressing risks faced at or near the target retirement date. For example, to better address the risks associated with inflation, many providers have increased the use of inflation-sensitive assets, such as Treasury Inflation-Protected Securities (TIPS).
  • As uncertainty mounts and market volatility ensues, retiree focused investment products are providing investment managers with increased flexibility to manage asset allocation decisions–relying less on the traditional “buy and hold” framework– in an attempt to better navigate the markets going forward.
  • The low interest rate environment has forced retirees to search beyond traditional sources for income-generating solutions. Popular sources of yield include dividend-paying stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), currencies, and emerging market debt.
    Of the various financial risks facing retirees, top of mind for many is longevity risk, resulting in the premature exhaustion of retirement assets. Longevity risk is the result of life expectancies being variable, which in turn creates uncertainty as to how much money will be needed to fund a retirement. In response, there are retirees on both ends of the spectrum—those that, perhaps unnecessarily, downgrade their lifestyles out of fear of depleting their nest egg too quickly, and others that pay little attention and spend too much too quickly.
Health care costs continue to rise faster than general inflation. This trend is particularly troubling for retirees’ since health care related costs often represent a growing portion of overall spending as they age

One of the only sources of guaranteed longevity protection for retirees, apart from Social Security and pensions are annuities. Unfortunately, many potential retirees have not accumulated enough wealth to rely on annuities as their single retirement income solution. According to EBRI, less than 60% of participants in their 50s and 60s had 401(k) balances exceeding $100,000 at the end of 2010.

At current rates, most annuities will generate far more income than lower-risk investments such as CDs and U.S. Treasuries, but are unlikely to provide the lifestyle most retirees expect to have during retirement. Based on quotes from, the average 65-year-old male would only receive $554 per month (a little more than $6,500 per year) for life from an initial $100,000 investment in a fixed annuity at today’s rates.

Clearly, no silver bullet investment solution can be crafted to overcome situations where retirees have failed to accumulate sufficient assets to meet their ongoing spending needs. The reality is many have mistaken a savings problem for longevity risk. While the economy, investment performance, and other variables do play a role in a retiree’s ability to accumulate an adequate retirement portfolio balance, for most, the primary factor in obtaining retirement security is their willingness to commit to a disciplined savings program.

Although potential and current retirees may have limited opportunities to address their savings shortfalls, there are ways to improve retirement security. Reducing spending by distinguishing between wants and needs, or prioritizing catch-up contributions to their 401(k) and/or IRA accounts offer two potential solutions. Perhaps the most impactful of the potential solutions is to work longer. By delaying retirement, individuals are provided additional years of continued contributions into their retirement portfolios, while potentially benefitting from rising capital markets. In addition, they reduce the number of years their retirement portfolio needs to support; and may delay filing for Social Security benefits, resulting in larger monthly payments down the road.

To meet retirement goals for soon-to-be retirees and for future generations, the golden rule should be start early and save more. The good news is that recent improvements to 401(k) plans—such as automatic enrollment, automatic escalation of contributions, increased flexibility in matching provisions and the increased use of asset allocation products—are helping employees save early, save enough and invest properly to accumulate a sufficient nest egg to fund their retirement expenses over their hopefully extended lifetimes.

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