Saturday, June 13, 2015

5 Things You Need to Know About Retirement Readiness

Recently the Government Accountability Office (GAO) released a report titled with its conclusion: “Most Households Approaching Retirement Have Low Savings.”

The title was no surprise — though the definitions of “most” and “low” bear further understanding.

The GAO Analysis
The GAO based most of its conclusions on findings from the 2013 Survey of Consumer Finance (SCF), conducted by the Federal Reserve every three years. It is a reputable and well-regarded source of consumer information, drawn from a sampling of about 6,000 households (different ones every cycle). That said, the information contained is “self-reported,” which is to say that it tells you what the individual thinks they have (or perhaps wishes they had), but not necessarily what they actually have. More on that in a minute.

The rationale for the “most” in the headline appears to come from its focus on households age 55 and older, where the GAO noted that (only) 48% had some retirement savings, and thus one might reasonably assume that the remaining 52% had no retirement savings — and that would seem to be the case. However, 23% of that 52% said they had a defined benefit plan. Now, that assessment may be inaccurate (see above), but if they do, in fact, have a DB plan, that plus Social Security might well be sufficient. So, “most” have no savings, but about half of that “most” might not need savings. Admittedly, that distinction makes for a clumsy headline.

What about the 29% who were age 55 or older, and who had neither a DB plan nor retirement savings? Well, the median annual income of that group was (just) $18,932. It’s not hard to imagine why that income bracket might not have set aside any savings for retirement. On the other hand, that group is probably well served by Social Security. Despite that income level, more than a third (35%) of those in this group say they own a home with no debt. Assuming that is the case (see “self-reported” above), that could make a big difference in their post-retirement expenses and/or represent an additional resource they could draw on for retirement income.

The GAO conclusions notwithstanding, here are five things you need to know about retirement readiness (and retirement readiness projections):

1. Social Security matters — especially for lower-income individuals.
Social Security remains the largest component of household income in retirement. In fact, GAO noted that for households age 65-74 with no retirement savings, Social Security makes up 57% of their household income on average. In fact, a quarter of this group rely on Social Security for more than 90% of their income.

For all households age 65-74, median annual income is about $47,000, and Social Security makes up on average 44% of income for households in this age group, larger than any other income source. About 90% of all households in this age range receive some Social Security income, and the median amount they receive is approximately $19,000.

The median income for households age 75 and older is about $27,000, and the median Social Security income is approximately $17,000. In fact, when compared to younger households age 65-74, Social Security makes up a larger share of household income for retirees age 75 and older, with 62% of these households relying on Social Security for more than 50%, and more than one-in-five (22%) relying on Social Security for more than 90% of their income.

2. Average or even median savings amount in the abstract tell you very little about retirement income adequacy at an individual level.

People live in different places and have different lifestyles and lifestyle expectations. They may have resources available beyond that reported in surveys such as the SCF, and individual health circumstances can make a huge difference in the adequacy of reported income sources vis-à-vis actual retirement spending requirements.

3. Pre-retirement income (or a percentage thereof) may not be a reliable proxy for post-retirement needs.

Many of these studies — and those cited by the GAO were no exception — use a “replacement rate” standard which, while it may be a convenient metric to use to convey retirement targets to individuals, has some serious shortcomings when applied to these large-scale policy models for determining whether an individual will run short of money in retirement.

The reality is that what and how we spend money pre-retirement often has little to do with our actual financial needs post-retirement.

As EBRI’s Research Director Jack VanDerhei points out, “…simply setting a target replacement rate at retirement age and suggesting that anyone above that threshold will have a ‘successful’ retirement completely ignores longevity risk, post-retirement investment risk, and long-term care risk.”

4. Many retirement projection models assume a 50% probability of success.
Aside from the shortcomings inherent in relying on a replacement rate for these projections, if you try to factor in longevity risk (the risk of running out of money in retirement), and post-retirement investment risk, VanDerhei notes that if you use a replacement rate threshold based on average longevity and average rate of return, you will, in essence, have a savings target that will prove to be insufficient… about 50% of the time.

Of course, when it comes to their retirement security, individuals tend to prefer something much closer to 100%.

5. Those who have a retirement plan are much better off than those who don’t.
Those with no retirement savings had a median income of approximately $29,000, while those in the same age range who have some retirement savings have a median income of $76,000. Among those age 55-64 with no retirement savings, the median net worth was $21,000 (about half of these had no wage or salary income), while among those in the same age bracket with any retirement savings, their median net worth was $337,000. In that group, the median income of those with no retirement savings was $26,000; among those with some retirement savings, the median income was $88,000.

Compared to those with retirement savings, these households (those aged 55-64 with no retirement savings) have about one-third of the median income and about one-fifteenth of the median net worth, and are less likely to be covered by a DB plan.

All of which suggests that it would probably be more meaningful to examine the retirement readiness of those without access to a retirement plan separately from those who do.

- Nevin E. Adams, JD

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