The Global Retirement Savings Gap

A recent publication "We'll Live to 100 - How Can We Afford It?" by the World Economic Forum examines the connection between increasing longevity, a decreasing dependency ratio (the ratio of those in the workforce and those who are retired) and the sustainability of the current retirement system.  Healthy pension systems are necessary to ensure a prosperous economy in the future; if retirees see that their post-retirement lifestyle is not sustainable from the time of retirement until they "depart this orb", it will have a significant impact on their consumption habits.  This would have an obvious negative impact on the global economy and its long-term stability.

Let's start by looking at some demographic issues:

1.) Increasing longevity:

The global population aged 66 years and older will increase from 600 million today to 2.1 billion in 2050.

2.) Oldest age at which 50 percent of babies born in 2007 are predicted to still be alive:

One of the biggest problems facing the global pension system is the dropping dependency ratio.  Right now, the ratio of persons in the workforce to persons in retirement is 8 to 1.  This is expected to drop to 4 to 1 by 2050.  This means that, in less than 35 years, the number of workers supporting retirees will drop by half.

Now, let's look at some economic issues:

1.) Lack of access to pension plans: on a global basis, over 50 percent of workers are in the informal or unorganized sector of the economy (i.e. self-employed) and have limited access to workplace retirement plans.

2.) Inadequate savings rates: to support a reasonable level of post-retirement income, workers need to save between 10 and 15 percent of their annual earnings.  This is particularly a problem where workers are covered by defined contribution plans which have no guarantee of benefits.

3.) High degree of individual responsibility to manage pensions: with the increase in the prevalence of defined contribution pension plans which now account for more than 50 percent of global retirement assets, individuals are now responsible for managing their own retirement savings.  This requires the individual to have at least some knowledge about how much they will need to retire and what investments will provide the necessary returns to achieve their savings goals.

4.) Low investment return environment: thanks to the world's central banks, returns on low-risk, interest-bearing investments that were traditionally the investment vehicle of choice for older investors, are well below historical averages with bonds yielding between 1 and 3 percent lower than historical values and equities yielding between 3 and 5 percent lower than historical values.  Additionally, high asset management costs in this low return environment have further punished investors.

With that background, let's look at the WEF's calculations for the global pension shortfall.  Their calculations assume that for most people, retirement will be financed using a combination of three sources of income; government, employer public or private sector pension and individual savings.  The analysis also assumes that post-retirement income will be 70 percent of pre-retirement income, a level that is likely low for low-income workers who are likely to need an income replacement rate closer to 100 percent of pre-retirement income.  Here is a graphic showing the size of the retirement savings gap in trillions of dollars in 2015 and in 2050 with the orange numbers showing the annual growth rate of the gap for the eight nations with the largest pension systems or populations:

In 2015, the retirement savings gap was estimated to be around $70 trillion among the eight nations which is approximately 1.5 times the annual GDP of these eight nations.   Based on WEF projections, the gap will grow by 5 percent annually, hitting approximately $400 trillion by 2050, a deficit growth rate of $28 billion daily.  Looking specifically at the United States, the retirement savings gap is growing by $3 trillion per year, equivalent to five times the U.S. annual defense budget.  Over the period from 2015 to 2050, the savings gap will grow fastest in both China at 7 percent and India at 10 percent because of rapidly aging populations, a high percentage of informal sector workers and a growing middle class.

The current $70 trillion retirement gap is composed of these components:

1.) 75 percent is unfunded government and public employee pension commitments.

2.) 24 percent individual retirement savings shortfall.

3.) 1 percent unfunded corporate pension commitments.

To close the current retirement savings gap and to prevent the gap from becoming a $400 trillion behemoth, the authors recommend that the steps need to be taken as follows:

1.) provision of a safety net pension for all to prevent those who do not have access to pension from dropping below the poverty line.

2.) improve ease of access to well-managed and cost-effective retirement plans; this is particularly a problem in economies like India's which has a high percentage of informal workers who have no access to any type of workplace pension system.  Governments could potentially make it compulsory that all employers automatically enroll all employees into retirement savings accounts.

3.) support initiatives to increase contribution rates through the use of phased-in automatic payroll deductions.

Unfortunately, in this time of extremely high levels of government indebtedness, it is highly unlikely that governments will be able to provide an enhanced publicly-funded pension system, in fact, the American Social Security system is facing insolvency in the next decade and a half.  As well, companies are facing significant underfunding levels of their pension plans, making it unlikely that they will take steps to enhance their retirement plans, in fact, many companies are moving from a defined benefit to a defined contribution pension system which puts all of the onus for funding one's post-retirement income on employees, many of whom have limited investing experience.  With the looming demographic nightmare of a high number of retirees and a dropping number of workers contributing to the pension system, I would suspect that the retirement savings gap is destined to continue to grow, leading to a "cat food future" for many retirees.

Saving for Retirement - How Much Is Necessary?

One of the big questions that faces today's Baby Boomers (as well as anyone that plans to retire in the future) is how much of a nest egg is needed to fund one's retirement?  Given the increasing usage of high cost drugs, the extremely high cost of long-term care and increasing longevity, this issue is of great importance.  A recent analysis by David Blanchett, Michael Finke and Wade Pfau gives us a good sense of what we have to save to fund a retirement, particularly this ultra-low interest rate environment.

Those of us that invested during the decades from 1970 to 2000 became quite accustomed to returns in the double digits; in the case of U.S. equities, between 1951 and 2000, stock prices grew at 5.89 times greater than the growth in dividends, a marked change from the period between 1875 and 1950 when stock prices rose in tandem with dividends and earnings.  The authors term the rapid growth in stock prices in the decades up to the year 2000 as "excess capital gain".  This unsustainable growth in equity prices has created an atmosphere where investors expect future returns that are inconsistent with the actual returns that equities can provide at current valuations; in other words, one of two things will have to happen:

1.) equities will either have to fall by more than 50 percent in order to maintain their historical equity premium or 

2.) investors will need to get used to a lower return on their equities in the future.

The authors state that in the current environment, it has become significantly more expensive to buy investment income than it was in the past, particularly since there are high valuations on risky assets (i.e. equities and earnings) and low yields on safe assets (i.e. bonds).  Here is a graphic showing how the cost of bond, dividend and earnings has changed since 1955:

Here are some examples:

1.) Interest income from a ten-year Treasury Bond - average price to buy $1000 in interest income since 1927 is $19,802; today, that same $1000 in income costs an investor $63,694.

2.) Corporate earnings - average price to buy $1000 in corporate earnings since 1881 is $16,671; today, that same $1000 in corporate earnings costs $27,812.

In the case of the Treasury Bond, the historical average interest rate is 3.5 percent; if interest rates on the ten-year Treasury were to rise from their current level to the historical average, the value of the bond would fall by 17 percent.  This means that, either way, Treasury investors will have to face the consequences of today's ultra-low interest rate environment.

Given this background, let's look at what the authors of the study have to say about what is needed for a financially secure retirement.  The amount required obviously varies with the return on retirement savings and longevity; for instance, if a household earning $50,000 at age 25 wants $1 million in purchasing power after age 65, in a scenario where they get a 5 percent real return they will need to save 10 percent of their income annually but if that real return drops to 2 percent, they will have to save 18 percent of their income annually.  Here is a graphic showing how much of an impact real interest rates and longevity have on the retirement income gleaned from $1 million in savings:

Obviously, an environment of low returns on investments increases both the percentage of income that a household needs to save for retirement as well as reducing the income that a household will receive once their savings goal is reached.  To reach the same level of retirement spending provided by $750,000 in savings (leaving behind a $500,000 legacy) at a 6 percent real return, households would have to save about $1 million in a 2 percent real return world.

Now, let's get to the meat of the matter.  Let's look at the author's Savings Simulation Model which estimates the required savings rate needed to maintain the same level of after-tax pay during retirement as the final year before retirement which begins at age 65.  All savings are assumed to be pretax (i.e. 401(k) or IRA.  While, in general, the income replacement level (i.e. the comparison between pre- and post-retirement income) is less than 100 percent since retirees tend to decrease spending during retirement, actual household spending levels during retirement vary widely and, in fact, may grow in the later years of life when retirees avail themselves of assisted-living arrangements.

Here is a table showing the total pre-tax savings rates for households starting to save for retirement at various ages, keeping in mind that the following assumptions have been made:

1.) "low returns" have real bond yields of 2 percent that remain at this level and "moderate returns" have real rates of return that rise slowly over time.

2.) savings rates would increase by approximately 25 percent over 10 years.

3.) improvements in life expectancies are used to estimate the retirement period, for example, retirement for a person that is currently 25 years old is likely to be longer than retirement for a person that is currently 65 years old.

4.) higher income households are likely to have longer lives than their lower income counterparts.

As you can see, the longer than households wait to save for retirement, the higher the required savings rate becomes.  For instance, a joint household with income of $100,000 would have to save 19 percent of pre-tax income annually in a low return environment and 16.5 percent in a mid-return environment whereas, at 25 years of age, the same household would have had to save 12.5 percent and 9.7 percent in low- and mid-return environments respectively.  There is one escape from this; by postponing retirement from age 65 to 70, for example, the optimal savings rate decreases as shown here for a couple that starts to save for retirement at age 35:

I realize that this is a great deal of information to absorb.  Please take the time to read the original paper which you can find here as it may help fill in the gaps.  In the current investment environment, research of this type provides all of us with a sobering look at how much we have to save to fund a financially satisfactory retirement.  Given the current ultra-low returns on so-called safe investments means that the task of saving for our golden years is harder than it has been for decades, thanks in large part to the actions of the world's central bankers.

America's Perfect Retirement Storm

The Economic Policy Institute recently completed its analysis of the state of the American retirement situation and it provides us with an interesting glimpse of the future that lies ahead for millions of Americans who think/hope that they will be able to rely on their 401(k) and IRA savings to supplement their meagre Social Security entitlements.  With the shift away from the predictable income streams of defined benefit pension plans, it is far more important that families save for retirements than it has been for generations, an issue that seems to be more that slightly problematic.

Here is a graphic that shows how aggregate retirement wealth has grown in the forms of defined contribution pension plans and IRAs as compared to defined benefit pension plans as a percentage of personal disposable income between 1989 and 2014:

On the surface, it looks like aggregate retirement wealth outside of defined benefit pension plans as a percentage of disposable income is growing at a very healthy rate, rising from 31 percent in 1989 to 106 percent in 2014.  There are, however, two important factors that this graphic does not show:

1.) retirement wealth outside of defined benefit pension plans should have increased more to keep pace with an aging population and cuts in Social Security benefits.

2.) retirement wealth outside of defined benefit pension plans is far more susceptible to economic risks since investment returns are not guaranteed, a factor that became obvious during the Great Recession. 

Let's start by looking at what has happened to the mean (i.e. the average) value of all retirement savings plans by families where the head of the family was between 32 and 61 years of age in 2013 dollars between 1989 and 2013:

While the average size of retirement savings accounts has grown over the quarter century in the study, a significant portion of this growth has been among older workers who have had longer to save for their golden years.  If you take a closer look at the data, you'll see that the average working age retirement savings account has only grown from $91,243 in 2001 to $95,776 in 2013, growth of just under 5 percent in a little more than a decade.  

Here is a look at what has happened the median (i.e. the midpoint between the highest and lowest or the 50th percentile) value of all retirement savings plans by families in 2013 dollars between 1989 and 2013:

EPI's analysis shows that nearly half of all families have no retirement savings whatsoever.  This pushes down the median value for all age groups raging from $480 for families in their mid-30s to only $17,000 for families between between the ages of 56 and 61.  In addition, you can clearly see that the balances in retirement savings accounts for most age groups are less than half of their pre-Great Recession peaks and are at levels substantially the same as they were at the turn of the new millennium. 

An analysis of Social Security benefits by Monique Morrissey at the Economic Policy Institute shows that Americans over the age of 65 in 2014 received an average of $12,232 annually, hardly enough to live on.  Obviously, retirees have no choice but to supplement their post-retirement incomes from their savings both inside and outside of their retirement savings plans like 401(k)s, defined benefit pension plans (which only 21 percent of Americans have) and, most importantly, income from employment.  This is going to be particularly crucial in the current protracted low interest rate environment where even a million dollar savings pot will only net a measly $1500 or thereabouts in annual interest income.

It is becoming increasingly apparent that retirement in the new millennium will not, in any way, resemble the retirement of the parents of the baby boom generation.  With the interaction of the following four factors...

1.) the decline in the defined benefit pension system

2.) the seeming inability of many families to save for their retirement

3.) the current environment of ultra-low returns on low-risk investments and

4.) the changes in the Social Security safety net. 

...it certainly appears that the perfect retirement storm is developing.

Retirement Insecurity in America - The Defined Contribution Debacle

Updated April 2017

A report by the Government Accountability Office looks at the challenges facing both present and future retirees in the U.S., particularly the state of retirement savings in the form of defined contribution pension plans.

As we know, there are two main types of pension plans:

1.) defined contribution (DC) plans: a pension plan where an employer, employee or both make contributions on a regular basis.  These plans are designed to help individual employees accumulate a sufficient level of retirement savings during their careers, often through deductions from an employees salary and contributions by an employer; these funds are deposited into an account in the individual's name.  DC participants shoulder the responsibility for any gains or losses in plan values since they decide how the accumulated funds are invested.  Under DC plans, taxes on both contributions and investment earnings are deferred until the benefits are received during retirement.  At retirement, the employee may take the assets of the plan as an annuity or as a lump sum.  

2.) defined benefit (DB) plans: a pension plan where an employer and employee contribute a percentage of an employees salary.  Rather than depositing the funds into an individual account, the funds are pooled and deposited into a pension fund that is used to pay its members a lifetime pension.  DB participants shoulder no responsibility for any gains or losses in plan values since the funds are managed by professionals.  Ultimately, it is the company that is responsible for any shortfall in pension funding.

In the United States, there are now five times more active participants in DC plans than there are in DB plans.  In 2013, DC plans comprised 94 percent of all employer-sponsored plans and active DC participants outnumbered those in DB plans 76.7 million to 15.2 million.  This means that there is no guaranteed post-retirement income for a very significant number of future American retirees and, given the low savings rate in many of those that actually do have investments in DB plans, it's looking like a very sad future for millions of older Americans.

The GAO report focusses on defined contribution plans and looks at how the participation in these plans varies by ethnicity and income group and the challenges that are posed by low participation rates.  Here is a summary of their findings.

The GAO estimates that, in 2013, 40 percent of all American households had some form of defined contribution (DC) pension plan leaving 60 percent with no savings in a DC plan from either a current or former job.  Since 2007, the number of Americans with no DC plan has increased by 3 percentage points since 2007.  Interestingly, an estimated 34 percent of working households (households with at least one person working but not self-employed whose head is between 25 and 64 years of age) have neither a DC or DB plan from a current or former job and, of households aged 55 and older, 29 percent had neither type of pension plan which means that Social Security along with any potential savings outside of a pension plan are their most significant source of retirement income.

Household income levels have a significant impact on DC participation and savings.  Among working prime-age (25 to 64 years of age) households, only 22 percent of low-income households (income less than $39,200) have any DC savings compared to 76 percent of high-income households (income greater than $109,200) as shown on this graphic:

The authors also note that the participation in DC plans changed markedly from 2010 to 2013 (the post-Great Recession period) for low income working households, dropping from 31 percent in 2010 to 25 percent in 2013 while the participation rate for all other household income levels remained constant as shown on this graphic:

Household income levels also have a significant impact on the percentage of households that participate in DC plans when those plans are available to them as shown on this graphic:

Again, notice that the participation rate for the lowest income households dropped by 13 percentage points between 2010 and 2013 while the participation rate for all other income groups remained more-or-less constant.  In part, the GAO notes that this is due to the fact that low income households do not have the disposable income that would allow them to participate in DC plans.  As well, some studies suggest that low income households have lower levels of financial literacy and that they aren't as aware of the tax benefits of such plans.  Additionally, the progressive structure of the U.S. tax code means that it is more advantageous for high-income earners to contribute to DC plans that their lower-income peers.

There is also a significant racial and ethnic component to both participation in and access to DC plans as shown on these graphics:

You will also notice that over the period between 2007 and 2013, the participation rate and accessibility to DC plans for White households actually grew slightly whereas both the participation rate and accessibility fell for both Black and Hispanic households.  In the case of Hispanic households, the access to DC plans fell by a very substantial 12 percentage points between 2007 and 2013.

Now, let's look at the impact of household earnings on the size of retirement income that participants receive from their DC plans.  The GAO baseline projections show that an average household would save enough in their DC plan over their careers to generate monthly lifetime income of $2970 (2015 dollars).  This table shows how that monthly income varies with household income level:

Households in the low-earnings quartile would only accumulate DC plan savings that would generate $560 per month in retirement income compared to $6380 for those in the high-earnings quartile.  In addition, 35 percent of households in the lowest-earning quartile would have no DC savings whatsoever compared to only 8 percent of those in the high-earnings quartile.

While the GAO report doesn't address this issue, there is one thing that has had a substantial potential impact on the future value of DC plans for all participants of all ethnic and income groups as shown on this graphic:

Thanks to the Federal Reserve's massive and lengthy monetary experiment, any American who wishes to save for their retirement and invest in low-risk fixed income investments has seen the return on those investments plunge to nearly zero.

The GAO's report clearly shows that a significant proportion of American households will experience a very insecure retirement.  This means that millions of Americans will have no choice but to supplement their meagre retirement savings and Social Security payments with part-time employment.  The change from a defined benefit to a defined contribution pension world has benefitted one group - Corporate America.  With so many American households lacking any form of retirement security, as I've said before, it's increasingly looking like a cat food future.