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[IWS] MEASURES OF RETIREMENT BENEFIT ADEQUACY: WHICH, WHY, FOR WHOM, AND HOW MUCH? [January 2013]
IWS Documented News Service
Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
Society of Actuaries
MEASURES OF RETIREMENT BENEFIT ADEQUACY: WHICH, WHY, FOR WHOM, AND HOW MUCH? [January 2013]
[full-text, 4 pages]
This report focuses on measuring retirement benefit adequacy in light of both expected and unexpected expenses in retirement and linking the measurement to the needs and objectives of different stakeholder groups. The report begins with a conceptual discussion of benefit adequacy and the various ways it has been and can be measured. Adequacy measures examined include replacement ratios, projected expenditures, and minimum societal standards. Both income needs and lump sum equivalents are considered. Different measures are better suited to the needs of different stakeholders and at different life stages.
The key findings include the following.
• Many of the next generation of retirees are facing a big drop in their standard of living when they retire.
• The median American married couple at retirement earns approximately $60,000 a year and has approximately $100,000 in non-housing wealth (based on the 2010 Survey of Consumer Finances, adjusted for wage inflation and recent market performance).
• The model shows there is a 29% chance median households will have positive wealth at death. The assets needed to meet cash flow needs 50 percent of the time would be approximately $170,000 compared to approximately $686,000 for a 95 percent success rate (See Table 10). Results are presented for two additional income levels and two wealth levels for each.
• There is no "one-size-fits-all" measure of benefit adequacy and there are many "moving parts" depending on the purpose and the stakeholder using it. Individuals need to be aware that attempts to over-simplify the retirement planning process can be very dangerous if used for personal decision making.
• The most appropriate measure of retirement benefit adequacy depends on the stakeholder: plan sponsor/employer; financial planner/individual; public policymaker; or financial institution.
• While it is much easier to plan for expected events, so-called "shock events" must be taken into consideration since they are more likely to derail an individual's retirement plan, especially at lower income levels. For the median income individual, shocks are the biggest driver of asset depletion
• Averages can be misleading in that they disguise the impact of shock events. The best strategies to preserve assets without shocks may not be the best strategies once shock events are considered. Making retirement decisions based on averages increases the risk of running out of money: The level of retirement wealth necessary to be 95% confident of having sufficient funds to meet all cash flow needs is much higher than what is needed on average. These extreme differences are largely driven by shocks and variations in investment returns.
• Retirement planning needs to continue after retirement as situations change. Individuals should also take a "holistic" approach that incorporates the interactions between various decisions and events.
• It is important to keep Social Security financially strong since it is a critical component of income for many retirees, especially those who are most at risk. Social Security dominates the results for the median income household (the $60,000 income scenario).
• Delaying retirement can significantly improve the likelihood of having adequate retirement income. This is the most effective risk management strategy for the median income household.
• The purchase of retirement annuities must be balanced against the need for an adequate emergency fund. Annuitization protects against longevity risk, but can divert assets that would otherwise be available to deal with shocks. However, even after wealth is depleted, a continuing annuity income stream will help to meet ongoing cash flow needs.
• Annuitization decisions involve important trade-offs and annuitization is not automatically the best choice. It is not feasible for lower income individuals and those with low financial assets. It is most likely to benefit the middle and upper income retiree with more assets. However, retirees need to be able to respond to financial shocks in addition to ensuring they don't outlive their income. Retirees should not focus on annuitization until they have an emergency fund. Further analysis is needed to identify the situations where annuitization is most helpful, and to understand how annuitization can interact with other decisions.
• It is important to consider and - to the extent possible - quantify the potential impact of shocks such as long term care. Low frequency, high severity risks can result in income inadequacy, particularly at lower middle income levels. This makes it more important to consider ways of mitigating the risk at those income levels.
• Moderate and higher income households can successfully retire with 20 percent less savings if they are willing to cut their budgets by 15 percent. Reduced spending does not significantly reduce the impact of depleting assets for the median family because shocks are the major driver of asset depletion.
• A variety of stakeholders can use this information. Policymakers can use it to understand population needs and relative importance of alternative policy options. Employers can use it to help them in planning benefit programs and communication. Markets can use this information to tailor their products to better meet needs. In particular, protection against long term care (LTC) risk is greatly needed, and this market needs to be strengthened.
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