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.
Monday, December 22, 2008
New paper: Can 401(k) Plans Provide Adequate Retirement Resources?
Monday, December 15, 2008
Issues with Ghilarducci GRA proposal: The cost of guaranteed returns
As noted here, Teresa Ghilarducci's Guaranteed Retirement Account plan would guarantee contributors a return of 3 percent above inflation. This sounds attractive, but is in fact a potentially very expensive proposition. Here's why. The Social Security Trustees project that the real return on non-inflation protected government bonds will be 2.9%; inflation-indexed bonds generally return around 0.5% less than nominal bonds since they're safer. So the GRA plan is promising returns higher than could be gained on similar market-based investments, which implies a subsidy. Moreover, returns on GRA accounts would be paid out from a fund invested in risky assets that would be managed by Social Security. Supposedly riskless returns backed by risky assets is a recipe for trouble – think about Fannie/Freddie, DB pensions and the Pension Benefit Guarantee Corporations, etc. I wrote about the costs of guaranteeing Social Security personal accounts here, and the underlying logic is the same here. A guarantee of a given rate of return is like a "put option," which allows you to sell an asset at a given price even if the market price of the asset has declined. You can put a price on this put option using the Black-Scholes formula. For instance, let's assume that you invest $1000 in a GRA account and have 20 years until retirement. At a 3% real return, that means the GRAs must repay you $1806. Let's also assume that the riskless interest rate is 2.5% and that investment fund backing the GRAs holds half stocks, half bonds, and has a volatility (meaning standard deviation of annual returns) of 12%. Given this, the cost of guaranteeing a 3% real annual return on a $1000 contribution is $272. (Here's a spreadsheet if you want to play with the numbers.) In other words, there's an implicit subsidy of around 27% on each GRA contribution. Given that total annual contributions could top $350 billion, a 27% implicit subsidy is a pretty big deal if it's not budgeted for. Probably the biggest lesson we should draw from the current financial crisis is to be very careful about guaranteeing market investments against market risk.
Problems with Guaranteed Retirement Accounts
The New York Times calls Teresa Ghilarducci's proposal for Guaranteed Retirement Accounts one of the "ideas of the year." Here's some background, and then in later posts I'll look at a number of problematic issues regarding the proposal. The following summary of the GRA plan is pulled from this paper Ghilarducci wrote for the Economic Policy Institute: How Guaranteed Retirement Accounts work Structure. Guaranteed Retirement Accounts are like universal 401(k) plans except that the government, as befits a large and enduring institution, will invest and manage the pooled savings. Participation. Participation in the program is mandatory except for workers participating in equivalent or better employer defined-benefit plans where contributions are at least 5% of earnings and benefits take the form of life annuities. Contributions. Contributions equal to 5% of earnings are deducted along with payroll taxes and credited to individual accounts administered by the Social Security Administration. The cost of contributions is split equally between employer and employee. Mandatory contributions are deducted only on earnings up to the Social Security earnings cap, and workers and employers have the option of making additional contributions with post-tax dollars. The contributions of husbands and wives are combined and divided equally between their individual accounts. Refundable tax credit. Employee contributions are offset through a $600 refundable tax credit, which takes the place of tax breaks for 401(k)s and similar individual accounts and is indexed to wage inflation. Eligibility for the tax credit is extended to part-time workers, caregivers of children under age six, and those collecting unemployment benefits. If an individual's annual contributions amount to less than $600, some or all of the tax credit is deposited directly into the account in order to ensure a minimum annual deposit of $600 for all participants. Fund management. The accounts are administered by the Social Security Administration and funds are managed by the Thrift Savings Plan or similar body. Though funds are pooled, workers are able to track the dollar value of their accumulations, as with 401(k)s and other individual accounts. Investment earnings. The pooled funds are conservatively invested in financial markets. However, participants earn a fixed 3% rate of return adjusted for inflation, guaranteed by the federal government. If the trustees determine that actual investment returns have been consistently higher than 3% over a number of years, the surplus will be distributed to participants, though a balancing fund will be maintained to ride out periods of low returns. Retirement age. Participants begin collecting retirement benefits at the same time as Social Security, and therefore no earlier than the Social Security Early Retirement Age. Funds cannot be accessed before retirement for any reason other than death or disability. Retirement benefits. Account balances are converted to inflation-indexed annuities upon retirement to ensure that workers do not outlive their savings. However, individuals can opt to take a partial lump sum equal to 10% of their account balance or $10,000 (whichever is higher), or to opt for survivor benefits in exchange for a lower monthly check. A full-time worker who works 40 years and retires at age 65 can expect a benefit equal to roughly 25% of pre-retirement income, adjusted for inflation, assuming a 3% real rate of return. Since Social Security provides the average such worker with an inflation-adjusted benefit equal to roughly 45% of pre-retirement income, the total replacement rate for this prototypical worker will be approximately 70%. Death benefits. Participants who die before retiring can bequeath half their account balances to heirs; those who die after retiring can bequeath half their final account balance minus benefits received. In following posts, I'll look at several aspects of the GRA plan that I think are worth considering more carefully before moving ahead.
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