America's Massive Retirement Savings Shortfall

As Baby Boomers age, the prospect of retirement income becomes increasingly important, particularly the necessity of having adequate retirement income.  The Employee Benefit Research Institute (EBRI) recently released a new version of its Retirement Security Projection Model (RSPM) that incorporates the impacts of freezes in defined benefit pension plans and the crises in both the housing and financial markets.  It also better reflects the real-world behaviour of the 24 million participants in 401(k) participants and the 20 million participants in individual retirement accounts (IRAs).  Through this process, EBRI is able to generate a national Retirement Savings Shortfall or RSS which is defined as the size of income deficits that households are simulated to generate in retirement.

One of the basic objectives of the RSPM is to simulate the percentage of the population that are at risk of having insufficient retirement income to cover average expenses and uninsured health care costs including long-term care costs at age 65 and older.  RSPM also provides information on the distribution of the likely number of years before those at risk run short of money and the percentage of pre-retirement compensation that they will require in terms of additional savings to provide a 50, 70 and 90 percent probability of adequate retirement income.

Here are the components that EBRI uses to define retirement household wealth:

1.) Social Security

2.) Defined Benefit Pension Plan annuities or lump-sum distributions

3.) Defined Contribution Pension Plan balances

4.) Net Housing Equity

5.) Individual Retirement Account balances

Let's look at how EBRI calculates cash flow for retirees.  The baseline model assumes that all workers retire at age 65 and that they immediately draw benefits from Social Security and any defined benefit pension plans.  To the extent that the sum of their living and uninsured medical expenses exceed their after-tax income from these sources, the retiree begins to withdraw funds from their IRAs, defined contribution and cash balance plans.  Individual accounts are tracked until they are depleted.  At that point, net housing equity is added to retirement savings as a lump sum (not as a reverse mortgage).  If all retirement savings are exhausted and if Social Security and defined benefit payments are not sufficient to pay expenses, the individual is deemed to have run short of money at that point in time.  

Here is a graphic showing the 2014 Retirement Savings Shortfalls at age 65 by age cohort, marital status and gender:

It is very important to keep in mind that this data includes the simulated life paths of retirees that will not run short of money as well as those retirees that will run short.  As well, these numbers are present values in 2014 dollars and represent the additional amount that individuals will have to save by age 65 to eliminate the possibility of running out of money.  The RSS values are largest for Gen Xers because it is assumed that health-care costs will increase at a faster rate than general inflation.

If we exclude retirees that will not run short of money, here are the modified Retirement Savings Shortfall amounts:

It is interesting to see how much of an impact home health care and long-term care costs have on the potential size of Retirement Savings Shortfalls.  Here is a graphic showing the RSS for Early and Late Boomers and Gen Xers if there are no nursing home or home health care costs:

For example, when single male Early Boomers who avail themselves of nursing home or home health care services, the present average value of the financial shortfall is $33,778 in retirement as seen on the first graphic.  If neither of these services are required, the shortfall drops to an average of only $10,201 as seen on the graphic above.  If long-term and home health care costs are ignored, RSS decreases by an average of 74 percent for all age cohorts.  Obviously, households or individuals that require long-term care or home health care assistance can suffer catastrophic financial consequences if there are insufficient funds to provide for these potential necessities.  

EBRI calculates that the aggregate retirement savings deficit number, taking into account the current level of benefit provided by Social Security and the assumption that the equity built up in housing is used when it is needed, is estimated to be $4.13 trillion for all U.S. households where the head of the household is between 25 and 64.  In a scenario where Social Security benefits are reduced starting in 2033, the aggregate deficit increases by 6 percent to $4.38 trillion.  EBRI's analysis shows that there is a very significant shortfall how Americans have saved for their retirement years, particularly in light of the current Social Security Trustees Report which projects that the funds for Old-Age, Survivors and Disability Insurance (OASDI) will be exhausted by 2033 which will result in a reduction in payments to retirees of approximately 22 percent in 2033 as shown on this graph which looks at OASDI income less cost:

Obviously, any future cuts to Social Security payments will make the Retirement Savings Shortfall calculated by EBRI look even worse than it already does.