Monday, December 22, 2008

New paper: Can 401(k) Plans Provide Adequate Retirement Resources?

The Investment Company Institute has released a new paper by Peter J. Brady titled "Can 401(k) Plans Provide Adequate Retirement Resources?" which simulates the benefits and replacement rates individuals could expect to receive through a combination of Social Security benefits and participation in a 401(k) investment account. Brady's paper can be seen in the context of the recent debate over the effectiveness of 401(k) accounts in furthering retirement preparation. Here's the summary:

Despite only having been in existence for 27 years - less than a typical working career - some analysts seem to have concluded that 401(k) plans are a failure. For example, Munnell and Sundn (2004, 2006) argue that the 401(k) is "coming up short" due to, among other factors, low contribution rates among those participating. A recent government report concludes that "low defined contribution plan savings may pose challenges to retirement security" (GAO, 2007). In addition, Ghilarducci (2006, 2008) has proposed to replace 401(k) plans with Guaranteed Retirement Accounts, in part due to belief that 401(k) plan participants will not be adequately prepared for retirement. This paper illustrates that moderate 401(k) contribution rates can lead to adequate income replacement rates in retirement for many workers; that adequate asset accumulation can be achieved using only a 401(k) plan; and that these results do not rely on earning an investment premium on risky assets. Using Monte Carlo simulation techniques, this study also illustrates the investment risk faced by participants who choose to invest their 401(k) contributions in risky assets, or who choose to make systematic withdrawals from an investment account in retirement rather than annuitize their account balance.

Brady's paper is very interesting and worth checking out.

For what it's worth, I should have an AEI Retirement Policy Outlook coming out next month which examines some similar issues. The table below shows combined Social Security and private pension replacement rates for the 1960 birth cohort as of age 70 (meaning, in the yea 2030). Replacement rates are adjusted for efficiencies of scale in household size, meaning that both pre- and post-retirement income is assumed to go further for couples living together with kids than for singles. (This adjustment process is one of the central points of the upcoming paper, and was inspired by recent work by Scholz and Seshadri and by Skinner). The simulations were conducted using the Policy Simulation Group models; they assume payment of current law Social Security benefits, and the assumptions regarding pension benefits are similar to those used in a recent GAO report.

Table 5: Distribution of Adjusted Total Pension Replacement Rates, 1960 birth cohort

Replacement rate percentile

Earnings decile

10th

25th

50th

75th

90th

10%

61%

77%

100%

131%

171%

20%

54%

69%

87%

113%

146%

30%

50%

64%

83%

109%

143%

40%

49%

63%

82%

109%

142%

50%

48%

62%

82%

109%

142%

60%

47%

62%

82%

109%

141%

70%

46%

61%

83%

112%

145%

80%

45%

60%

83%

111%

144%

90%

43%

61%

84%

113%

150%

100%

33%

50%

72%

99%

130%

While there's much more to be said than can be outlined here, the main point is that – even assuming declining replacement rates from Social Security and the imperfections of the 401(k) system – projected replacement rates for most future retirees aren't bad, particularly since this analysis excludes other sources of retirement income (e.g., earnings, non-pension savings, implicit rent from housing). For reference, most financial advisors recommend a retirement income equal to around three-quarters of income during pre-retirement years.

3 comments:

William said...

"Can 401(k) Plans Provide Adequate Retirement Resources?" which simulates the benefits and replacement rates individuals could expect to receive through a combination of Social Security benefits and participation in a 401(k) investment account.

I see no reason why this cannot be the case. The only problem I have is you cannot continue with SS-OASI while workers are attempting to save through a 401(k). The reason is very simple, what additional resources do you use to contribute to a 401(k)?

Do people decrease spending by 15%? This would hurt the economy.

Do people stop contributing to other retirement avenues such as IRA, savings and stocks? If they do, is this not just a shift from one retirement form to another with no net new savings?

Do you cut SS-OASI taxes enough so that people can continue to spend as they have for the past 50 years? If you do what do you do with current retirees?

The only way 401(k) can be a true alternative to SS is that new money must flow into them. Not money that was destined for IRA’s, savings or other investments.

Many think today’s workers or young spend too much on frivolous stuff. If we were to go back 100 years, what would they think about the spending of the 1930’s? Would they think cars were a frivolous, how about heating, electricity, trains, radio, theaters and more? The entire standard of living structure is based on doing things better, cheaper and faster thereby freeing up human capital to do something else. What that something else has been is nothing more than “frivolous” stuff that has put millions to work, making lives more enjoyable. In the past it may have taken 85% of our resources to meet the basic necessities of a log cabin, food and animal clothes. Today by freeing up 90% of population to do something besides farming, hunting, and building log cabins, we have some building roads, computers, providing power, radios and all the other products today. If we expect workers to cut back in order to save, then the standard of living must drop to accommodate those displaced workers until such time that productivity has improved enough to utilize them.

A society that save 15% of their income yearly can produce retirement benefits for all of 92% of pre tax take home pay for life adjusted for inflation. It is a push-me-pull-me economy. The problem with SS is that is artificially stimulated the economy beyond the natural capacity to sustain it. The 15% that once was saved by individuals for individuals was shifted to the SS and Medicare with the “promise” that it would pay benefits in the future. Instead of being set aside to build the infrastructure of the future, they were consumed allowing many to compete for products they would not have purchased otherwise. Now we have benefits that cannot be paid without extolling excessive taxes on our children.

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