Map "Quests"

I’ve been hooked on the convenience of GPS systems ever since the first time one was included in the price of a rental car on a family trip in unfamiliar territory. After all, it combines the opportunity to tinker with electronic gadgetry alongside the convenience of not having to do much in the way of pre-planning trip routes—not to mention avoiding the need to stop and ask for directions (that is frequently associated with not doing much in the way of pre-planning trip routes).

There are, of course, horror stories about drivers who have blindly followed GPS instructions without paying attention to the evidence of their eyes. My family still chuckles at the memory of a trip where we were running late to our plane, and the rental car GPS, based on what appeared to be an outdated address for the return office, kept directing us to an address that was not only miles from the real office, but a place from which I wondered if we might never return.

As a growing number of Americans near, and head into, retirement, policymakers, retirement plan sponsors, and individual workers alike increasingly wonder—will Americans have enough to live on when they retire? Unfortunately, as a recent EBRI publication[1] explains, the answers provided are as diverse, and sometimes disparate, as the projection models that produce those results.

While it is not always clear from their results, some of those models limit their analysis to households already retired, while others focus on households still working, but old enough that reasonably accurate projections regarding their future wages and prospects for accumulating retirement wealth are obtainable. Still others attempt to analyze the prospects for all working households, including those whose relative youth (and distance from retirement) makes accurate, long-term predictions somewhat problematic.

Moreover, there are varied definitions of retirement income adequacy. As the EBRI report explains, some either (1) model only the accumulation side of the equation and then rely on some type of preretirement income replacement rate measure as a threshold for success, or (2) make use of a so-called “life-cycle” model that attempts to smooth/spread some type of consumption-based utility over the decision-maker’s lifetime.

The problem with the former is that, since very few households annuitize all (or even most) of their individual accounts in retirement, a replacement-rate focus overlooks the potential risk of outliving their income (longevity risk). And while the annuity purchase price relied upon in a replacement-rate target does depend on an implicit assumption with respect to (at least some) future market returns, it does not typically account for the potential investment risk. Additionally, and as previous EBRI research has demonstrated, one of the biggest financial obstacles in terms of maintaining retirement income adequacy for households that might otherwise have sufficient financial resources at retirement age is the risk of long-term care costs for a prolonged period. In the real world, few retirees have long-term care insurance policies in place that would cover the potentially catastrophic financial impact of this exposure—and thus, simply adding the cost of long-term care insurance into a replacement-rate methodology will vastly underestimate the potential severity of this exposure.

As for the life-cycle smoothing model, the EBRI report notes that approach typically produces extraordinarily low levels of “optimal” savings for low-income individuals at retirement, and while some households may, in fact, have no choice but to subsist at those levels in retirement, from a public policy perspective EBRI chose instead to establish a threshold that would allow households to afford average expenditures (for retirees in the appropriate income category) throughout their retirement, while at the same time accounting for the potential impact of uninsured long-term care costs.

EBRI’s Retirement Security Projection Model^®[2] takes a different—arguably unique and more realistic—perspective. Rather than relying on an individual’s projected ability to achieve an arbitrarily designated percentage of his or her preretirement income as a proxy for retirement income adequacy, RSPM grew out of a multiyear project to analyze the future economic well-being of the retired population at the state level, focused on identifying the point at which individuals would run short of money and perhaps become a financial obligation of the state.

As valuable a resource as a GPS can be, it can quickly become a nuisance—or worse—if the input destination point is incorrect, or the mapping system is out of date. Similarly, those who want a financially secure retirement may find that relying on a model based on flawed assumptions or outdated “destinations” may find themselves short of their goal and with little time to do anything about it.

Nevin E. Adams, JD

[1] See ““’Short’ Falls: Who’s Most Likely to Come up Short in Retirement, and When?” online here.

[2] A brief description of EBRI’s Retirement Security Projection Model® can be found online here.

"Control" Group

Last week I was speaking at a conference on the West Coast when a weather pattern emerged that threatened both my connecting flight, and my arrival at home. Alerted to the potential problem, I began seeking alternatives. Eventually, I was able to reroute my connecting flight—though doing so meant a later arrival at my home airport and, based on the trajectory of the storm, that later arrival increased the likelihood of running into problems there.

I continued to check in back home during the day—trying to gauge the storm’s progress, and to (re)evaluate my alternatives. As I boarded that final leg of the trip home, I knew a couple of things: The flight was (still) departing on time, and while it wasn’t snowing at home (yet) the forecast was now for more snow, starting later. The trip home wasn’t exactly restful (despite the hour), but having done what I could to minimize the impact of the storm on my travel, having attended to the things I could control, I boarded the plane, hopeful that the combination of my new route home, the pilot’s skill, and the storm’s track would result in a satisfactory, if somewhat stressful, conclusion.

Earlier this year EBRI was approached by Money Magazine to use the EBRI Retirement Security Projection Model® (RSPM)¹ to evaluate a number of potential retirement preparation scenarios, taking into account varying levels of household income, debt, marital status, retirement plan participation, health, etc. Selected results from that analysis, published in the March issue (see “Dream Big, Act Now: Six Secrets of Retirement” online here), showed the impact that various factors could have on the chances of running short of money in retirement.

Real as those factors are, many of life’s circumstances are completely beyond our control. However, some of the most important factors—including the decision to participate in a workplace retirement plan, or the amount we choose to save—are not. Consider a 45-year-old female worker who is currently making $50,000/year, with a current retirement savings balance of $50,000. Applying the RSPM model,² we find that if she contributes 1 percent of pay to her retirement savings each year, there is a 61 percent chance that she’ll run short of money in retirement. On the other hand, a 10 percent annual contribution rate (which could be her’s along with an employer match) reduces that probability to 38 percent, while a 15 percent annual contribution rate reduces that risk to just 1 in 4 (see chart below).

My flight home from the conference was never risk-free, even before Mother Nature decided to throw a wrench into my carefully designed itinerary. That said, having the potential problem highlighted early enough allowed me to take steps to avoid the worst of what surely would have been a very long and arduous flight home, arriving home two hours later than I had originally planned, but well ahead of my likely arrival had I stayed on my original flights.

Much of today’s retirement planning tends to focus on things over which we, as individual retirement savers, have no control—things like investment returns. Perhaps those looking for true retirement serenity might, like those who invoke the so-called “Serenity Prayer,” be better advised to seek “the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference.”

- Nevin E. Adams, JD

¹ RSPM grew out of a multi-year project to analyze the future economic well-being of the retired population at the state level. After conducting studies for Oregon, Kansas, and Massachusetts, a national model—the EBRI Retirement Security Projection Model® (RSPM)—was developed in 2003, and by 2010 it has been updated to incorporate several significant changes, including the impacts of defined benefit plan freezes, automatic enrollment provisions for 401(k) plans, and the recent crises in the financial and housing markets. EBRI has recently updated RSPM for changes in financial and real estate market conditions as well as underlying demographic changes and changes in 401(k) participant behavior since January 1, 2010 (based on a database of 23 million 401(k) participants).More information, and a chronology of the RSPM is available online here.

² This application of the RSPM assumed stochastic returns with an average of 8.9 percent for stocks and 6.3 percent for bonds.

“Better” Pill?

As a growing number of Americans near and enter retirement, concerns about the cost of post-retirement health care expenses loom larger. In fact, worker confidence about their ability to pay for medical expenses after retirement was just half what they expressed about their ability to pay for basic retirement expenses (see EBRI’s2012 Retirement Confidence Survey).

Little wonder, since a recent EBRI Issue Brief noted that health-related expenses are not only the second-largest component in the budget of older Americans, they are the only component which steadily increases with age (see “Expenditure Patterns of Older Americans, 2001‒2009”).

Recognizing the potential financial impact, recent industry surveys have put a figure on the cost of post-retirement health care expense¹—a figure above and beyond that of merely living in retirement. EBRI has gone to great lengths to model the major risks to retirement income adequacy all the way back to the introduction of the EBRI Retirement Savings Projection Model (RSPM)® in 2003, including the incorporation of stochastic health care risks, such as nursing home and home health care costs.²

The RSPM has incorporated those expenses because, while those events will not be experienced by all retired households, or experienced to the same extent, when they do occur they can have catastrophic financial consequences for a household’s future retirement income adequacy. Many attempts to model retirement income adequacy either ignore this risk altogether, or just assume that all households purchase long-term care insurance at retirement—the former ignores a significant financial reality, while the latter glosses over reality.

Indeed, a major limitation of using income replacement rates as an accumulation target is that doing so generally fails to take into account these potentially catastrophic costs. How much difference does this make? A recently updated version of the RSPM³ shows that, with the financial impacts of long-term care (nursing home and home health care costs)modeled, 68 percent of single male Gen Xers are projected to have no financial shortfall in retirement. On the other hand, if those long-term care costs are ignored, fewer than one-in-ten would be projected to run short of funds in retirement. Similar results were found for single female and married Gen Xers.

The gaps are even more noticeable if you focus only on the situation of individuals with projected shortfalls in excess of $100,000. Ignoring long-term care costs, fewer than 1 percent of single male or married Gen Xers are projected to have shortfalls in excess of $100,000; however when you take those costs into account, approximately 18 percent of single males and 10 percent of families are now in this range, according to the model. The results are even more pronounced for single females, where ignoring those long-term care costs would indicate that fewer than 5 percent are modeled to experience shortfalls of more than $100,000, compared with approximately 34 percent when this reality is factored in.

It’s clear that those long-term care costs can be significant, and can have a dramatic impact on retirement security.

What’s less clear is why projections of retirement income needs and preparedness would continue to overlook them.

Nevin E. Adams, JD

Notes

(1) For more information, see “The Impact of Repealing PPACA on Savings Needed for Health Expenses for Persons Eligible for Medicare,” EBRI Notes, August 2011, online here.

(2) The Retirement Security Projection Model® (RSPM) was developed in 2003, and in 2010 it was updated it to incorporate several significant changes, including the impacts of defined benefit plan freezes, automatic enrollment provisions for 401(k) plans, and the recent crises in the financial and housing markets. EBRI has recently updated RSPM to account for changes in financial and real estate market conditions as well as underlying demographic changes and changes in 401(k) participant behavior since January 1, 2010. For more information on the RSPM, check out the May 2012 EBRI Notes, “Retirement Income Adequacy for Boomers and Gen Xers: Evidence from the 2012 EBRI Retirement Security Projection Model,®” online here.

(3) More information about this update will be published in June 2012 EBRI Notes.