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.