Critical Mass: Defined Contribution Can Transcend State of Crisis

by Richard Davies

The vast majority of Americans are saving too little to fund their future retirement needs, and US defined contribution (DC) plans cannot single-handedly make up the difference. The American retirement system is in crisis. According to the Employee Benefit Research Institute (EBRI) and Mathew Greenwald & Associates, 57% of American workers surveyed in March 2013 reported that they had less than $25,000 in total savings and investments (not including the value of their primary residence or defined benefit plans). And fewer than 20% have between $25,000 and $99,000 in savings—retirement or otherwise. This disheartening scenario has led some in the retirement industry to a state of hopeless inertia, while others are determined to scrap the entire DC system and start afresh. But we disagree with pundits who say the existing DC system can’t be fixed. In our view, DC plans and participants already have the right tools to significantly improve retirement outcomes. And the changes that must be made don’t need to be painful. Indeed, combining only modest adaptations can effect major change. Losing Ground As explained in our recent research paper, The Future of DC Has Arrived: Improving Retirement Outcomes Now, just a few key variables drive a DC plan participant’s ability to achieve a comfortable retirement: the asset-allocation mix of the glide path, the savings rate before retirement, the spending rate after retirement, and age at retirement. When plan sponsors and participants make relatively small changes at the same time to the settings of these variables, retirement outcomes can improve dramatically. But under current capital-market conditions, without altering these variables, participants are losing ground—fast. The blue profile in the display below shows how a typical DC participant would fare in a historically normal market environment. The upward-sloping line describes the period during which the participant saves and his or her assets grow. The peak corresponds to retirement (in this case, at age 65). The slope of the line declines as the participant begins to spend assets during retirement. The goal is for the participant’s money to last to—if not beyond—his or her life expectancy. Our model indicates that, in a normal environment, the typical DC participant’s wealth would be depleted at age 91. That’s just the median experience, however. The box-and-whiskers graphic below the profile shows that what the participant experiences depends a lot upon market conditions. In favorable conditions, the wealth lasts longer; in unfavorable conditions, not as long. Whiskers to the right and left represent best and worst cases under normal market environments (where the whiskers are not truncated by our 105-year age limit). At first blush, a median of age 91 seems like a good outcome for a typical participant. That’s three years longer than the expected lifespan in 2050! However, we don’t expect market returns to be normal for the foreseeable future. Bond returns in particular are likely to be low as interest rates rise off multi-decade lows. That must be factored into our analysis. With the green profile, we applied capital-market conditions consistent with these expectations. These lower expected returns cause the participant to run out of money four years before his or her average life expectancy of 88. Here we’re finally seeing the potential impact of the retirement crisis from another vantage point. And this is just the median outcome. In a poor market environment (25th percentile), the picture becomes even more abysmal. All Together Now But it doesn’t have to be this way. And the solution doesn’t have to be painful, either. (That may be the best news yet.) We began with the same basic assumptions underlying our display above and then modestly adjusted just three of our variables—the asset allocation, the savings rate and age at retirement—as shown in the display below. For comparison, the green profile of the first display remains here as the sample scenario. The result of the concurrent modifications (shown in blue) is hugely successful. Not only does the money last through age 100 in the median outcome, but the bottom 25th percentile is now above our sample scenario’s median of 84 years, where most DC plans will end up if they fail to take action. We encourage you to explore our recent research and recommendations. You’ll learn which variable adjustments are most and least successful, find examples of other potential combinations, and get practical advice for putting these ideas into place. Because together, we can turn this crisis around. And we can do it now.

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