I’ve been hooked on the convenience of GPS systems since the first time one was included in the price of a rental car on a family trip in unfamiliar territory. There are, of course, horror stories about drivers who have blindly followed GPS instructions without paying attention to what they can see with their own eyes. As valuable a resource as a GPS can be, they can quickly become a nuisance — or worse — if the input destination point is incorrect, or the mapping system the route relies on is out of date.
As a growing number of Americans near, and head into, retirement, policymakers, retirement plan advisors, plan sponsors and individual workers alike increasingly wonder — will Americans have enough to live on when they retire? Unfortunately, as a recent EBRI publication notes, the answers provided are as diverse, and sometimes disparate, as the projection models that produce those results.
In addition to the variability in underlying assumptions in these models, there are varied definitions of retirement income adequacy. As the EBRI report explains, some either (1) model only the accumulation side of the equation and then rely on some type of preretirement income replacement rate measure as a threshold for success; or (2) make use of a so-called “life-cycle” model that attempts to smooth/spread some type of consumption-based utility over the decision-maker’s lifetime.
The problem with the former is that, since very few households annuitize all (or even most) of their individual accounts in retirement, a replacement-rate focus overlooks the potential risk of outliving their income (longevity risk). Moreover, while the annuity purchase price relied upon in a replacement-rate target does depend on an implicit assumption with respect to (at least some) future market returns, it does not typically account for the potential investment risk.
Additionally, in the real world few retirees have long-term care insurance policies in place that would cover the potentially catastrophic financial impact of this exposure — and thus, simply adding the cost of long-term care insurance into a replacement-rate methodology will vastly underestimate the potential severity of this exposure.
As for the life-cycle smoothing model, the EBRI report notes that approach typically produces extraordinarily low levels of “optimal” savings for low-income individuals at retirement, and while some households may, in fact, have no choice but to subsist at those levels in retirement, from a public policy perspective EBRI chose instead to establish a threshold that would allow households to afford average expenditures throughout their retirement, while at the same time accounting for the potential impact of uninsured long-term care costs.
EBRI’s Retirement Security Projection Model® takes a different — and arguably unique — perspective. Rather than relying on an individual’s projected ability to achieve an arbitrarily designated percentage of his or her preretirement income as a proxy for retirement income adequacy, the RSPM grew out of a multiyear project to analyze the future economic well-being of the retired population at the state level, focused on identifying the point at which individuals would run short of money and perhaps become a financial obligation of the state. (A brief description of EBRI’s Retirement Security Projection Model® can be found online here.)
So yes, a GPS can be a valuable a resource. But if the input is incorrect or the mapping system is out of date, they can quickly become a nuisance or worse. Similarly, and as retirement plan advisors know, if you’re aiming for a financially secure retirement, it’s important that the model you use to chart that course not be based on flawed assumptions or outdated “destinations” — or you could find yourself short of both your goal and time to do anything about it.
