Are Saving More and Working Later the Only Options to Improve Retirement Readiness?

In a Pension Research Council working paper, Catherine Reilly, senior investment strategist, defined contribution, at State Street Global Advisors (SSGA), and Alistair Byrne, head of investment strategy, European defined contribution, at SSGA, state that expected low market returns paired with increasing longevity will make it tougher for future retirees to have sufficient income replacement rates in retirement.

After performing an analysis based on certain assumptions so that only the effect of lower expected market returns is measured, the researchers find that a hypothetical individual currently 60 years old and who retires at age 65, having been saving since age 22, could expect to achieve a 211% replacement rate from his defined contribution (DC) savings alone. In addition, he can expect to receive Social Security and may well have some defined benefit (DB) plan benefits as well. The paper authors note that while few 60-year-olds may have been in a DC plan since the age of 22, they could have made contributions to a retirement savings account by themselves.

By contrast, an individual currently 25 years old and who employs the same saving strategy could expect to achieve a 27% replacement rate from his DC plan if he was to retire at age 65. Furthermore, the younger individual is unlikely to have any DB entitlements and faces more uncertainty regarding the amount of Social Security that he will receive. The researchers note a 45-year-old individual can expect better outcomes than the 25-year-old but is also disadvantaged compared to the 60-year-old.

The researchers contend that the most obvious tactics that younger workers could adopt to improve their situation are to contribute more and to work longer. For example, a 25-year-old could reach a 40% replacement rate by contributing about 13.5% and working until age 65; by contributing slightly above 10% and working to age 70, or by contributing about 7% and working to age 75. A 35- or 45-year-old benefits from stronger historical returns, so either can achieve the target replacement rate at slightly lower contribution rates. The researchers also note that individuals who start the retirement saving journey late face more challenges, yet they can also significantly improve their retirement readiness with a disciplined approach to saving and by postponing retirement.

However, this assumes consistent savings behavior during the entire working life, no career breaks, and no leakage from retirement savings.

The researchers suggest policy changes that could improve retirement outcomes for younger individuals and/or late savers. One alternative policy would be to allow individuals to take out partial Social Security benefits rather than obliging them to always take the full benefit. For example, the paper notes, in Sweden, people who have reached the minimum age of eligibility for Social Security (62) can take a 25%, 50%, 75%, or 100% benefit, and modify this percentage when desired at an actuarially fair rate. There is also no maximum age by which full payments must start. Another option would be to give people a choice to defer the start of Social Security benefits beyond age 70, to make the most efficient use of Social Security’s cost-efficient longevity insurance. “This would make it possible to use Social Security as a longevity backstop providing the main source of income in late life, rather than a steady source of income throughout retirement,” the paper says.

As an example, the researchers note that in Australia, eligibility for the Age Pension is based on an asset test, reassessed annually, rather than retirees’ age. People are not eligible for the Age Pension until they have drawn their assets down to a minimum level, after which they receive a flat rate Age Pension for the rest of their lives.

Other than Social Security policy changes, the researchers suggest mandating automatic enrollment in DC plans and automatically escalating contribution rates would be effective for improving retirement outcomes. In addition, they note that matching contributions encourage voluntary employee contributions up to the match threshold. Reducing retirement plan leakage would also be helpful.

The researchers note that although some people may not be physically able to work full-time past retirement age, part-time work may be feasible for many.  A question the researchers posed, but did not address fully is how employers will facilitate and value older workers.

The full working paper is available here.