Even if DC plan participants do everything right — start saving early, save sufficient amounts and invest prudently — a new analysis shows that retirement outcomes can vary widely along with financial market ups and downs, even among workers who practice the same saving and investing behaviors.
The Towers Watson analysis looks at retirement income results for workers who retired from 1916 to 2015 — hypothetical workers who started contributing 6% of pay to their DC plans at age 25 and stopped saving when they retired at 65.
TDFs Versus Balanced Funds
The analysis projects results for two investment approaches. In the first one, workers allocated 60% to stocks and 40% to bonds, rebalancing annually to hold this mix steady over their careers. In the second approach, workers opted for a target-date fund throughout their 40-year career. Here the analysis assumes that the fund allocated 88% of contributions to stock at age 25, with the stock share decreasing to 34% in the final year of employment. (They also assume a 100-basis-point charge annually for investment and administrative expenses.)
Under the 60/40 investment approach, workers’ account balances ranged from almost twice (191%) to more than six times (619%) their final average earnings (this among workers retiring between 1916 and 2015). However, under the lifecycle approach, while the overall outcomes were slightly more consistent, the variance was still large, with results ranging from twice (207%) to more than five times (554%) final earnings.
That said, while both investment strategies produced a wide range of outcomes, the authors note that lifecycle funds offered a pronounced advantage over the last 10 years. Between 2006 and 2015, a worker with a 60/40 allocation amassed from 363% to 490% of average final earnings, while a worker with a lifecycle fund retired with between 458% and 517% of final earnings. During this admittedly tumultuous economic period, the lifecycle approach mitigated workers’ losses from the 2008 financial crisis to what the authors described as a much greater extent than the 60/40 approach.
Withdrawal Rates
Then, assuming retirees started with their ending account balances as derived above, withdrew 25% of their final average earnings annually, and kept the remaining balance in a 60/40 stock/bond allocation, there is still a considerable variance in results, reflecting ups and downs in investment performance over time. Some retirees’ savings ran out in 12 years (at age 77), while others’ savings lasted for 28 years (to age 93). In fact, in 64% of their projected outcomes, the hypothetical workers exhausted their account balances before age 86. This is significant in that as of 2015, roughly one of four 65-year-olds will live past age 90, according to the Social Security Administration. In the Towers Watson model, workers’ retirement income from their DC plans lasted beyond age 90 only 16% of the time.
The analysis goes on to note that one way workers can manage withdrawals while ensuring they don’t outlive their money is by converting their DC account balance at retirement to an annuity, but that while an annuity provides income security, its purchase introduces another level of variance and complexity due to fluctuations in the interest rates that are used to calculate annuity values. The analysis then assumed that retiring workers had identical account balances in all 100 years of simulations and converted their savings into immediate life-income annuities, based on a unisex life table and interest rates at the time, while also assuming constant life expectancy and a 15% load on the annuities for insurer expenses/profit.
Annuity Purchases
Even after controlling for stock and bond performance, retiring workers still faced uncertainty in retirement income due to fluctuations in the interest rates used for annuity conversions. For example, a worker retiring in 1982 — when interest rates were at historical highs — was able to replace 31% of working income. But Towers Watson notes that a worker retiring five years later — after interest rates had declined — could replace only 19% of preretirement earnings, despite spending the same amount.
Over the 100-year period, income replacement rates ranged from 12% to 31% of preretirement pay for workers who all started with the same DC account balance at retirement.
