Retirement Income Security

Friday, November 05, 2010

There is growing concern that many American workers will not have sufficient income during retirement years to maintain an adequate lifestyle during their retirement years. Increased life expectancy, elimination of traditional Defined Benefit pension plans, a decline in the number of employers who offer retiree health care, and double digit increases in health care have placed many future retirees at significant financial risk. This could result in an increased dependency upon public programs, families, and force many workers to remain employed well past their normal retirement age. Combined with the possibility of future reductions in Social Security benefits, means testing, and Social Security’s lack of ability to keep pace with inflation, planning for retirement income security is essential to all workers regardless of income levels.

In a 2009 analysis written for the Organization for European Economic Cooperation (OEEC), which includes the US, author and economist Pablo Antolin suggests that retirees will need 70% of their pre-retirement income to sustain their current lifestyle. To achieve this, Antolin suggests that a worker must save between 5% and 15% of their annual earnings. Antolin goes on to point out that for workers in countries e.g., the US, where the predominant form of retirement income is Defined Contribution plans; workers will have to assume that the majority of their retirement income will come from such plans.

To model and test Antolin’s assumptions of a 5% and 15% savings rate of their annual earnings and a target income replacement level of 70%, consider a hypothetical worker Rick. Rick entered the workforce at age 26 with a starting salary of $12,864, Rick’s salary grew at an average of 5% annually over his career, Rick worked until he was 65 with a final salary of $82,143. Using 70% as a target replacement for his pre-retirement income, Rick will need about $57,500 to maintain his standard of living from all of his post retirement income sources. Based on Rick’s final earnings it is estimated that his Social Security replacement income will be approximately $31,214. Therefore, Rick will needs an additional $26,286 annually to meet the 70% threshold.

• Assuming that Rick saved 5% of his annual earnings and had an average annual rate of return of 5%, Rick will have a balance of $168,187 in his DC plan. This balance is certainly not enough to last more than about 8 ½ years, assuming the same 5% annual rate of return, or for about half of Rick’s remaining life expectancy.

• Assuming that Rick saved 15% of his annual earnings and had an average annual rate of return of 5%, Rick will have a balance of $504,562 in his DC plan. This balance is certainly enough to last more than Rick’s life expectancy of age 81-83.

It appears that Antolin’s assumptions of a 5% savings rate may be on the low side for a country such as the US where the social insurance system has a relatively low-income replacement rate. On the other hand, a 15% savings rate of annual earnings may be too high. Of course the actual savings rate is going to vary by each individual based on their personalized needs and circumstances.

Before making changes in retirement investments and planning, individuals should seek out professionals in the financial planning, legal, and accounting expertise and who have recognized credentials of national professional organizations. The examples provided here are for illustrative and academic purposes only and should not be taken literally.