Can You Afford to Retire?

jack vanderhei

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Jack VanDerhei is a faculty member at Temple University and a research fellow at the Employee Benefit Research Institute (EBRI), a Washington-based benefits industry think tank. In this interview, he discusses the rise of 401(k) plans and delves into EBRI's database of 16.5 million 401(k) records to show how much Americans are saving, what they need to be saving, the problems in the 401(k) system, and what can be done to fix them. This is an edited transcript of an interview conducted on Feb. 7, 2006.

Jack, you've been studying pensions for a very long time, and you've seen enormous changes in the pension systems -- this whole shift from the defined benefit plan, which is a lifetime benefit, to the defined contribution, which is limited by the amount of money [saved], and the shift of responsibility and risk from companies to individuals. How big are the changes, and what do they mean?

The changes happen in two phases. Think of one as the accumulation phase, [when] you're still working. In a defined benefit plan, you didn't have to do anything as the employee. If you were covered, everything was taken care of. Under defined contribution, you have to decide whether to participate. You have to decide, if you do, how much to contribute. You have to decide where to invest those assets. And if you change jobs, you have to decide whether you're going to roll over that money or spend it. …

But then you hit retirement, and that's the type of situation that many individuals don't understand at all. They kind of understand things like investment risk while they're still working, but now [they] hit retirement age, and it's not that [they] have an employer saying, "I will give you X dollars per month the rest of your life, no matter how long you live." Instead, you have an account balance. You have a lump sum, and unless you actively choose … to go out and annuitize that --

-- "Annuitize" -- that means buy an annuity?

Buy an annuity from [an] insurance company that says, much like the defined benefit plan, "I'll give you X dollars a month the rest of your life, no matter how long you live." Unless you choose to do that as an employee, then you're faced with a situation where you have to guess how long your retirement phase is going to last. If you guess a period too short, you may very well run out of money, even if you thought you had enough saved. That's a subtle distinction for many individuals who I don't think [yet] realize what the shift to defined contribution plans has meant to their need to plan financially.

When the 401(k) proposition was first written into law in 1978, [and] the Treasury and the IRS issued a ruling [allowing employees to contribute from their pay] in 1981, at that point, did people following retirement understand the implication of this thing?

I think in November '81, … very few individuals had any idea what this was going to evolve into. In most cases, this was nothing more than a supplemental plan for employees who were already covered by defined benefit plans. It was very rare back at that time to find 401(k) plans as being the exclusive retirement vehicle for the employees.

I think ... very few individuals had any idea what this was going to evolve into.

So what pushed it? Was it the mutual fund industry? Was it financial planners? What made 401(k) plans take off?

I think there were a large number of reasons, and it depended a lot on the company's situation. … You had contribution requirements that were tightened up in 1987 which made defined benefit plans less optimal from a cash-flow perspective. You had many employers who wanted to have the employees share the cost of the plan. If you want to have employee contributions on a defined benefit plan, it has to be after-tax contributions. 401(k) plans had a natural advantage that if employers are going to put money in, they can do it on a before-tax basis.

So they get a tax break with a 401(k).

Exactly.

The early 401(k) plans, were they primarily for executives and managers and people who were well paid, and then the IRS had regulations that said no, you had to also offer them to the ordinary rank and file?

There were a series of events in the mid-1980s that basically, through nondiscrimination requirements and other things, caused a 401(k) plan, if it was to retain its qualified status, to have all employees participate, or at least a large percentage of them.

At the Employee Benefit Research Institute [EBRI], you follow retirement. When you look at the record, particularly with these 401(k) plans, how well are people doing in terms of saving?

… We have a database that actually goes back 10 years now. … These are administrative records; they're not survey data, so you don't have to worry about [whether] the participants actually remember what they have in their balance. Right now, we have data on 16.5 million participants from about 45,000 different 401(k) plans.

Wow, that's a lot. When you look at that data, what do you find out about the generation that's just about to retire -- folks between, like, 60 and 65? how much have they saved in those 401(k) plans?

On average, it turns out that approximately three times what they have as their final salary is what their account balanses are for those currently on the verge of retirement.

Uh-huh. So if we're looking here at people making $40 or $50,000 a year, they're got a $100, $150,000 in their 401(k).

Right. … But the thing that you have to keep in mind is that the 401(k) system literally has only been in place about 20 years, so these individuals only had an opportunity to spend about half of their career in these plans. So by and large, it's probably not going to be enough, when combined with Social Security, to help the people right on the verge of retirement have adequate retirement income.

Presumably, though, as more and more and more years are spent within the 401(k) system, by the time the other end of the baby boom generation hits retirement age, all of our simulations show that typically anywhere from one-half to two-thirds of their pre-retirement income will be replaced from 401(k)s alone. When you add Social Security onto that, that suggests a very comfortable retirement, as long as they participate in the 401(k) plans.

But there is going to be a segment of the population -- it always has been, this is nothing new -- that basically get to retirement age and have nothing but Social Security to retire on. That has been the case for many, many years, and will continue to be the case unless something would happen to increase not only participation rates among employees who are offered these plans, but something to get employers, especially small employers, incentives to offer retirement plan coverage in the first place.

When you say half the workers in America don't have a plan -- 401(k) plan or any kind of plan -- … it's because they're not offered that by their employers. Is that right?

It's a combination. Sometimes they're not offered one by their employer. Sometimes they're offered one, and through whatever combination of reasons -- oftentimes because they don't have enough income to be able to afford to save currently -- they choose not to participate. …

And that's half the people in America in any given year?

For the private workforce. Public is entirely different.

So if they work for the state or the federal government, they've got some kind of retirement plan?

It's almost always defined benefit, where there is no choice involved.

They've got roughly three times their annual pay. They're going to get Social Security. With that kind of money, how many years is that going to carry them at a good retirement rate? How many years will this cover them?

Well, if they want to have about 80 percent of what they were making prior to retirement, from a combination of their 401(k) balances and Social Security, that will probably carry most of these people for seven or eight years. After that you basically have nothing but Social Security. It's very difficult to see how a standard of living would be maintained for the average life expectancy if they have nothing to supplement this.

And what's life expectancy if you retire at 60 or 65?

Around 17 years.

So we're talking a gap -- eight or nine years where these folks are going be just down at Social Security level.

For those that don't have anything else other than Social Security and these 401(k) plans, that would be correct.

Now, if you turn the question around and say, "What do I need in my retirement account so that, along with Social Security, I can make it?"

That's a very good question. If you have nothing but Social Security and your 401(k) accounts, if you want to retire [with 80 percent of your pre-retirement income] at 65, and you're male, [you have to have] about 6.3 [times your pre-retirement annual income]; if you're a female, about 6.7. The reason, of course, is you have a longer life expectancy if you're female than male. If you want to retire early -- say, at age 60 -- those numbers are going to increase up to about 6.9 [times pay] if you're male, and about 7.2 [times pay] if you're female.

So let's translate this into dollars and cents. You've got Social Security. You're looking to maintain your living standard. If you want to retire at 65, and you're making $50,000 a year, you have to be in the neighborhood of $300,000, $325,000 in your 401(k) plan.

That's correct.

And if you want to retire at 60, you're looking at $350,000, $360,000, $370,000.

Right.

And most of the people we're looking at are half that or a little bit below.

On average, yes.

What does it take, if you're working for 30 years and you're in a 401(k) plan -- that's all you've got: 401(k), Social Security -- how much do you have to put aside every year? What percentage of your salary?

… If you're a male and you want to get out at age 65 -- you're going to work those 30 years you mentioned -- about 13.3 percent total. That's the employer and the employee together -- 13.3 percent of compensation each and every year.

Wow.

If you're talking about a female getting out at 65, it goes up to 14.1 percent -- again, because of the longer life expectancy.

What if you want to retire at 60?

… For the male, it goes from 13.3 to 14.5 percent a year. For the female, it goes from 14.1 up to 15.3 percent a year.

So whatever you're doing, you're saying 14 or 15 percent a year is what you're going to need to be putting in 30 years in a row.

Combined employer-employee, that's correct.

An awful lot of employer-employee plans are not -- the employee puts in, max, 6 percent, employer matches 3 percent, [so] 9 percent total. We're falling far short.

For those individuals who are putting in only enough to get the maximum out matched by the employer, I agree entirely with that.

How many people are putting in more than the max, percentage-wise, out of your 16.5 million?

More than the maximum amount matched? From the records that we have looked at thus far -- and they are a few years old at this point -- I would say over half of the people are putting in more than the maximum amount matched. …

So you've got a very substantial number doing more than maxing out. And when you look at younger groups, what do you find out?

Probably exactly what you expect. It's harder for the younger individuals to put in more than the amount that's being matched by the employer. What they do tend to do is make up for it later on in life. … It's almost like [the employer match is] the default. The employer provides a signal: "I will match up to 6 percent." If you don't tell the employee anything else, a lot of them just naturally assume 6 percent is the amount to put in. … Right now, you have a lot of people in these 401(k) plans that have not seen a generation of retirees truly go through any kind of financial calamity. I think that when you see people starting to run out of money, you might find 401(k) participants in the younger cohorts taking the cue and starting to increase their savings rates.

So you're suggesting these folks, unless they've got something else, they're headed for some kind of financial calamity seven, eight, nine years down the road, and they may be a warning for the next generation?

I would certainly think so. … If you take a look at the averages, the combined employer and employee contribution together, you're going to end up someplace between 9 and 11 percent [of annual income]. Obviously, as you get older, it tends to increase. But obviously, those averages aren't even coming close to being enough to hit that 80 percent replacement rate, when combined with Social Security.

… This is going be a shock to people. Do people understand what the financial requirements of retirement are? … Do people understand life expectancy, medical expenses? What do [people] need to think about?

… I think the comprehension of anything beyond investment risk is virtually [none]. You have individuals who have no concept of how long they might live, … their complete exposure to things like long-term care costs. They assume, in many cases, that if they have to go into a nursing home, Medicare takes care of it, which [it doesn't]. … Until they sit down and actually pay a financial planner to do this for them, or go through the trouble of filling out the forms -- whether it be on a Web site or paper-based -- themselves, they have no idea whether they're even close to being on track for what they need for retirement. …

They need to factor in a number of things. One of the things that had been quite common for previous generations of retirees that is becoming less and less common now is the employer actually providing retiree health coverage. Those types of things seem to be becoming less and less common in the workforce, so employees have to worry about how they're going to meet health care costs which are not picked up by Medicare.

They're also going to have to worry about longevity risk. It's one thing to know, if I retire at a particular age, how long on average I'm going to live. But if you save just for that average, then 50 percent of the time you're going to outlive the amount of money that you've saved. One very, very easy way to treat that is through purchasing a life annuity at the time of retirement. That will guarantee you a set amount per month as long as you live.

So the real danger is longer term. … Are we looking at retirement villages that are going to look like poorhouses?

Well, you have to somehow figure out what's going to happen. Either they're going to be taken care of by their children, or there's going to have to be some sort of social aspect of taking care of retirees who simply have run out of money other than Social Security. … Keep in mind what we're looking at here is people who have 401(k)s. Those are the people who are going to be in the better part of the distribution. There's about half the people in private employment who are not participating in any retirement plan. … Those are the individuals who truly have something to worry about, because, in essence, nothing but Social Security is going to be provided for them.

How do you describe this? Jack Bogle, the founder of Vanguard, talks about it as a gathering storm. I think you said some people are headed for a calamity. People don't have a sense at the moment in America that the retirement system as a whole is in real trouble. They may say, "Oh, well, General Motors or IBM or United Airlines, it's over there." But the way you're talking, this is a generic problem across the board.

We've done simulations for the entire population -- not just the people that are in the 401(k) system -- and what we find is, for many cohorts, looking at when you were born, whether you're male or female, whether you're married or not, and, most importantly, how much you're making, the average amount of additional savings they would need … -- and I'm not even talking 80 percent replacement rate; I'm talking about decent standard of living -- they would have to start saving, on average, more than 25 percent of their compensation each and every year, which, of course, is not a feasible situation.

Because we're so far behind.

That's exactly right.

Well, that's a disaster in the making.

It certainly would appear that way.

And do people hear it? Are people getting that message?

We have done studies for the state of Oregon, for the state of Massachusetts and for the state of Kansas, and I know in at least two of those cases they have tried ... to assist retirees, whether it be providing tax breaks for long-term care insurance, whether it be to educate the individuals. But there's a problem out there. All of these things that we model assume status quo -- assume Social Security benefits do not reduce; assume Medicaid payments for the low-income individuals, if they have medical problems, are not cut back. Given the problems that the states have with their budgets, given the problems we have … [with] Social Security, those are best case scenarios.

So we're looking at tough facts, but you're saying these are almost rosy scenarios compared to what could happen. Do Americans get this tough picture? I don't have a sense that people are aware of this.

Beyond looking at … some type of financial planning software, I don't think the vast majority of individuals have any idea what's coming down the road as far as some type of social outcome. … People tend to minimize what they think their life expectancy will be. They tend to assume that they're going to continue in relatively good health if they currently have disastrous medical history. … Things like long-term care insurance are not actively purchased. [Buying an annuity] is not something that's done very frequently. … Because of retiree health insurance being shifted to the employees, [they] are basically one misstep away … from financial ruin. … They don't factor in the fact that a year or two in a nursing home could totally disrupt their entire financial plans. …

When you look at the 401(k) program, what are the biggest problems in it? If you had to tick off three or four things, what are the main weak points?

Well, number one is … the low participation rates among young and low-income workers; [second], contribution rates which are necessarily only going to get the maximum amount matched by the employer and no more; thirdly, the way you invest.

There's two problems with investments. You've got a whole group of people, even young employees, who are so risk-averse that they don't invest anything in equities. Now, it's one thing if you're 64 and a year away from retirement, thinking, well, I don't want to face a down market, and pulling out. But if you're talking about people in their 20s and 30s who don't have anything in equities, you're simply not going to have a large enough rate of return to get investment income to supplement your contributions to give you the kind of standard of living you're going to need in retirement. That's one problem.

The other problem is diversification. We still have more than 10 percent of employees … that have 80 percent or more of their entire account balance invested in company stock.

What's wrong with that?

… The problem is you not only have your entire job future invested in that company, but now you have your entire retirement security also. It's much easier to diversify at least portions of that risk by getting in a broadly diversified equity index fund.

So you've got too much at risk in one place, … too many eggs in one basket. … Participation, contribution, investment -- OK. What's number four? What's the next big problem?

Among the young and those with small account balances, which is not necessarily … constrained to only the young, there is an extraordinarily high probability that when you leave one job for another, that instead of rolling over those monies to an IRA or to a new employer or keeping it with the old employer, you'll actually take the monies out. … Once that money is out, it's probably never going to go back into your overall retirement accumulation.

How big is this problem of leakage, of people cashing out their 401(k) plan when they move from one job to another?

The problem is actually quite large. If you look at people in their 20s, about 70 percent of the people cash out [their 401(k)s]. If you even go up into the 30s, you're still talking about maybe 55 percent of individuals cashing out their account balances -- monies that were there for retirement being spent on other purposes.

So the whole idea of saving for 40 years goes out the window, and suddenly you're now saving for 20 or 25 years.

Exactly.

That's a major problem.

Yes.

When people retire and they get their hands on the money, is there a danger that someone will spend the money too fast because they don't have any idea how long they're going to live? How can you track that?

If you take a look at some of the government studies that have been done in the last 10 years that track individuals every two years after they retire, and you compute how much they should be spending each year to be able to maintain [their savings] to at least life expectancy, … you find a substantial portion of them spending down the monies [more] quickly than they should in that case.

A substantial portion? Ten percent? Fifty percent?

It's certainly around 25 percent to 30 percent under most assumptions we've made.

So if you're saying most people didn't have a sufficiently large 401(k) balance to begin with, are you then saying on top of that, 25, 30 percent of them are spending out their balances too fast?

Right.

As a nation, we're dependent essentially on defined contribution, and that means mainly 401(k) plans. Are major fixes needed in the 401(k) system?

I would say there are many fixes that are relatively easy to accomplish that would get much of the perceived problem taken care of almost instantaneously.

Such as?

Automatic enrollment. Automatic enrollment takes care of those low-participation-rate problems we mentioned.

The other thing is, employers have tended to put [employees' monies] into default investments which are very low risk. The problem [is that] low risk means low expected return. If you're sitting in a money market fund or something similar to that on day one when your employer puts you in that, you have a tendency to stay in there. If the employers thought that they would be safe by putting employees in an age-appropriate equity position as a default investment, all the simulations we've run show that account balances for these individuals would increase substantially, especially for the low-income individuals.

The other thing -- if you want to go out to something perhaps more radical -- is … stricter penalties for pulling monies out of the retirement system. … Increased tax penalties, maybe even restrictions on pulling money out, I think would go a long way to curbing the leakage problem that you suggested earlier.

Other things that you might want to consider [are], what happens at retirement age? Should, perhaps, a portion of the monies be mandated to be annuitized? … If you look at a package of those types of revisions -- and some of those have been suggested in recent legislation -- you would go a very long way to curbing the problems that many 401(k) participants today experience.

If you are summarizing it to share with your wife or your brother-in-law, what would you say to them?

I would say, unless you're fortunate to be in the upper-income quartiles, that you're probably going to be in for a very rough ride; that the amount that you're going to have to save over and above what's already being provided from Social Security … is going to be a substantial percentage of compensation, much more than people are saving today. And you probably … are not going to be anywhere close to having adequate retirement income.

And what does a rough ride mean?

A rough ride means you're not going to have sufficient monies to pay the predictable expenses -- your housing, your utilities, your food -- plus the potential catastrophic medical care costs that you might be burdened with, things like a nursing home.

And you're talking about the middle of America. You're talking --

Absolutely. I'm talking that person right in the middle, going 10 percent either way, … between the 40th and 60th percentile in income. That's middle America.

They're in for a rough ride.

Very rough.

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posted may 16, 2006

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