Editor’s Note: Clicking on the studies referenced here will open a new browser and take you to that paper. At the end of this article are links to a quiz that will test your investment IQ and to several retirement planning calculators.
The widely-accepted estimate is that it will take 70 percent of pre-retirement income during retirement to maintain one’s pre-retirement standard of living. That income will need to come from some combination of social security, a company pension, personal savings, and continued work. The question is, what percentage will come from which source, and what will it take in the way of savings to meet that goal.
Fortune Magazine recently did a study in which it estimated the percentages of income from each of these sources for 1992 retirees and for those who will retire in 2029. For 1992 retirees, in aggregate, 8% of their income comes from traditional Defined Benefit Pension plans that guarantee a particular amount of income, 19% comes from Social Security, 27% from continued employment income, and 46% from investment income, including Defined Contribution pension plans such as 401(k) and personal savings. For the 2029 cohort, they estimate that only 4% of the income will come from traditional Defined Benefit plans. They further assume a 50% cut in Social Security and Medicare benefits for purposes of the study, dropping the total percentage of income from that source to 7%. Investment income rises to 48%. But because investment income has not risen fast enough, more people will have to work longer and more hours if their model is correct. They estimate that two-fifths of aggregate income (41%) will have to come from continued employment.
A recent study conducted for Merrill Lynch by Douglas Bernheim supports the Fortune position. Bernheim’s study indicates that boomers should be saving, on average, three times as much as they currently are in order to avoid a precipitous decline in their standard-of-living in retirement. He agrees that without fundamental changes in patterns of saving, many boomers will be forced to keep on working during the “retirement” years or accept a significant reduction in their standard of living at that time.
According to the Employee Benefits Research Institute, “A consistent 20 – 25% of working Americans are very confident that they will have enough money to live comfortably through their retirement years.” Data from a recent study by the authors that is reported below suggests that some of this confidence may be misplaced. Even if correct, however, the other “three out of four American workers have no idea about how much money they need for retirement” (Office of Investor Education and Assistance). When asked in a recent survey by this department of the US Securities & Exchange Commission how much they thought they would need, “most respondents said they were afraid of the answer, considered the process too complicated, or didn’t have the time” to think about it. If people don’t even know how much money they will need, it is fairly certain that they are not adequately addressing the question of what they need to do now to remedy the situation.
The problem of anticipated shortages of retirement funds due to the lack of proper retirement planning and saving is compounded by the inability of the government to guarantee sufficient funds to make up the difference. Social Security has been one of the landmark social programs of the New Deal, but the program was never intended to be a total retirement fund, only a social safety net. Nevertheless, Americans have come to rely heavily on Social Security payments to provide the necessary funding for retirement. According to a 1994 survey by the Bureau of the Census, 16% of the over-65 population currently relies on Social Security for 100% of their income, and a full two-thirds of those over 65 receive half of their income from Social Security (Congressional Research Office).
There is good reason to believe that if coming generations rely this heavily on Social Security, their standard of living will indeed fall. A recently completed a study by the Heritage Foundation on Social Security found that while workers close to retirement have experienced relatively good returns on their contributions, workers in their 20’s and 30’s will receive a far smaller return on their social security taxes. The realities of demographics and politics means that even Baby Boomers cannot expect to receive the same relative level of benefits that current retirees receive because there will be fewer workers to pay the taxes to support this type of pay-as-you-go retirement system. Generation X faces serious problems associated with what is now viewed by some as a government Ponzi Scheme. Interestingly enough, however, a recent poll commissioned by the “Gen X” organization 2030 found that young people do want Social Security to survive and believe it is possible to reform it.
Social Security has been a political winner until now. But the simple truth of the matter is that future benefits will need to be cut by some mechanism, or the entire system will fail. By the government’s own projections, Social Security trust funds will be depleted by the year 2032 unless there are changes in the system. This projection includes the gradual increase in the age at which one can obtain full benefits from the current age 65 to 67 that is already written into law. There are numerous proposals being debated about ways to save the system, and it is likely that Social Security will remain in some fashion. It is very clear, however, that those who want a comfortable retirement should not count on this program to fund it. Personal savings will be more important in the future than they have been for current retirees.
Another compounding problem is the previously-mentioned shift in employee retirement programs. Retirement funds are disproportionately being shifted away from Defined Benefit Plans (DBPs) to Defined Contribution Plans (DCPs). Typically, the DCPs do not include retirement health care, a frequent component of DBP’s. As health care is a major expense of older people, this is a significant shift from employer to employee. Furthermore, the worker has the added responsibility of managing and monitoring the investment decisions of retirement accounts.
Not only is the responsibility and risk for retirement planning shifting away from corporate America to the worker, increasing percentages of workers are doing freelance work, are working for small companies that do not offer retirement plans at all, or are shifting jobs frequently and therefore not getting vested in retirement plans that may exist. Clearly we are in a period where the individual is going to be much more responsible for his or her own future than has been true before.
There have been numerous studies that question the ability of Americans to actively manage not only their financial affairs in general, but their retirement affairs in particular. The later point is emphasized by the oft-cited fact that the United States has the lowest savings rate of the G-7 nations at 4.1%. Japan (15.3%) and Italy (14.3%) experience savings rates over three times higher. This relatively low and stable US savings rate reinforces the argument that the lack of savings is a serious long-term problem with particularly grave consequences for retirement planning.
Problems stemming from the deficiency of retirement monies are complicated by the lack of knowledge and skills necessary to manage retirement account funds. Savers could earn more on investments and pension benefits if they understood the basics of investing and the behavior of financial markets. These additional funds, benefited by compounding, would alleviate the looming shortfall and subsequent decline in the standard-of-living.
The Institute of Certified Financial Planners noted in a 1993 study that 53 percent of planners surveyed indicated that their clients had great difficulty with retirement planning and implementing investment strategies. It should be noted that the very act of contacting planners suggests that these clients are already ahead of most Americans. They have recognized the problem and sought a pragmatic solution to it.
The problem is serious enough that the Office of Investor Education of the Securities and Exchange Commission, along with a number of other organizations has organized a “Facts on Saving and Investing Campaign.” Noting that “at a time when more Americans than ever before are investing in our securities markets directly through the purchase and sale of stocks and bonds, numerous studies show they lack the financial basics.”
These findings are verified by a survey recently conducted by the authors. Using a questionnaire designed to test individual participant knowledge on diverse topics such as risk, diversification, financial advisor qualifications, taxes, stocks, valuation, business math, the impact of changes in interest rates, exchange rate risk and global investing and mutual fund performance, a sample of 264 college-educated adults were tested on their investment knowledge. A perfect score on the quiz is ten points, with seven points or higher suggesting that one has mastered the investment basics. A score of five to seven suggests that one must do some reviewing prior to making any big investment decisions, while less than five indicates a serious deficiency of basic investing knowledge.
The majority of those taking the test were currently employed (84%), about half were married (45%), about half were home-owners (49%), and most were optimistic about America’s future (83%). Only 12% did not have retirement accounts, and most owned stock (70%) through IRAs (40%), 401Ks (68%), other pension plans (17%) and/or participation in investment clubs (25%). Most were covered by life insurance (67%) and 24% owned annuities.
Seventy-seven percent of the respondents reported that they felt adequately prepared for retirement. This optimism exists despite the fact that only a third of them anticipate receiving any benefits from social security and Medicare.
The results suggest that these respondents are overly-optimistic about their abilities to handle their investments. The overall average response was slightly over five correct answers out of the ten. It would appear that they may well be participating in financial investment vehicles and markets they do not understand, even at an elementary level.
When broken down, the results suggest that those who are actively involved in investing tend to have a better grasp of investment basics than do others. Therefore, participation in pension plans at work may be one way of becoming knowledgable. Firms can provide information and encouragement to employees about investing, and may well benefit by instilling a sense of loyalty and trust. KPMG employed Merrill Lynch to educate its employees and the initial results were an increase in salary deferred to almost 9% compared to KPMG’s 5 to 6% historical average.
How much will you need to invest or save to maintain 70% of your pre-retirement income in your golden years? These calculators are similar in many ways, but each has some special features and you may want to review them all before deciding which to use. The last two contain features that suggest the types of asset allocations that may be appropriate based on the information provided.
Read the assumptions on these calculators carefully however, particularly those about the rate at which investments will be compounded. Historically, the overall stock market has risen at an annual rate of less than 10% over the long-term, not the 17%-20% that people have experienced in the past two or three years. A difference of even one or two percent (e.g., 8% vs. 7%) can make a sizeable difference in the estimated value of a portfolio over a period of 30–40 years.
The American Savings Education Council’s “Ballpark Estimate” Planner
The Motley Fools Retirement Calculator
Vanguard Retirement Resource Center
Fidelity Retirement website