Why individuals need to save more for retirement and how to figure out how much more you should save.
In this episode you’ll learn:
- How life expectancies have changed over the decades.
- Why traditional defined benefit rose in prominence and then declined.
- How much should you save to retire.
- Why most retirees might eventually need the help of an annuity.
A Brief History of Retirement
The idea of retirement is a relatively recent concept. In the late 19th and early 20th centuries, 75% of males over the age of 65 were working. If they weren’t working, it was usually because they were disabled. Life expectancy back then was only 49 years and if one was fortunate to be alive at age 60, they could expect to live another twelve years to age 72.
This and the other retirement data I quote in this article are from the “Timeline of the Evolution of Retirement in the United States” prepared by the Georgetown University Law Center. By 1935, when the Social Security Act passed, a 65-year-old could expect to live another twelve years until age 77.
Today, according to the Social Security Administration, the average 65-year-old male can expect to live until age 84.3 and the average female until age 86.6. One out of four 65-year-olds will live past age 90.
The Growth and Decline In Defined Benefit Plans
In 1940, 15% of private sector workers were covered by private pension plans. Most private pension plans were defined benefit plans where the worker and in some cases his or her spouse received a monthly pension payment for the remainder of the beneficiaries’ lives based on years of service at the company and their salary.
Defined benefit plans have plan assets that are overseen by the corporation sponsoring the plan with the help of outside advisors, such as actuaries, investment managers and consultants. The percentage of workers covered by private pension plans rose to 25% in 1950, 41% in 1960 and peaked at close to 46% in 1980.
In 1978, Congress passed an act which allowed for pre-tax employee contributions to deferred compensation plans, which we now commonly know as 401(k) plans or defined contribution plans.
The term “401(k)” refers to the Internal Revenue Service tax code section that addresses these plans. 401(k) plans were never intended to replace traditional defined benefit plans. Yet, today only 18% of private sector workers are covered by defined benefit plans.
Why the significant decline?
Why Companies Prefer 401(k) Plans
Corporations found matching employee contributions in a deferred compensation plan, such as 401k, was significantly cheaper and less risky for the company.
No longer do businesses have to worry about adequately funding their employees’ retirement and earning a sufficient return to pay future benefits, a challenging task given increasing life expectancies. The Bureau of Labor Statistics estimates per plan participant costs for defined benefit plans are 70% higher than for defined contribution plans.
The Downside To 401k Plans
What is less risky for companies ends up being significantly more risky for employees, most of who are woefully unprepared to invest for retirement. Most employees don’t have actuarial consultants advising them how much they should save for retirement.
Most employees don’t have investment consultants helping them select an appropriate asset allocation or select managers. Most employees aren’t able to access some of the higher returning asset classes available to private pension plans such as venture capital, private real estate, private energy, timber, and farmland. Employees also don’t have the buying power to negotiate lower management and other professional fees available to corporations managing pension plan assets. Instead, employees are often left with high cost mutual funds and other plan expenses.
How Much To Save
A 2015 survey by the Employee Benefit Research Institute indicated 27% of workers had no idea what percentage of their household income they should save for retirement. 20% thought they needed to save more than 30% of their income to retire comfortably while 8% thought the amount needed to be less than 10%. The answers were all over the place and more than 60% were not confident about their answer.
The same survey indicated 35% of respondents had less than $1,000 in savings and investments, apart from their primary residence and defined benefit retirement plans. 61% of respondents had less than $50,000 in savings and investments. The reality is most individuals have no idea how much they should be saving for retirement and most, if they are saving at all, are probably not saving enough.
A low return, low interest rate environment like we are currently experiencing requires traditional pension plans to increase their contributions in order to fund future benefits. Likewise, individuals saving for retirement need to increase their annual contribution amount to offset lower expected returns.
Households should be saving 15% to 20% of their pre-tax income including company matches if they don’t have access to traditional defined benefit plans. Most households are not saving enough and will be heavily reliant on Social Security to fund the bulk of their retirement spending.