I have spoken in previous articles about the proverbial three-legged stool that in the historical world of financial preparedness describes the concept of the three most common sources of retirement income: Social Security, an employer’s retirement or pension plan and personal savings.
Many recognize that these three historically relied-on retirement pillars have dramatically changed. A struggling Social Security program will likely be a much smaller percentage of one’s retirement income for future retirees. The number of private sector companies offering Defined Benefit (DB) Pension Plans has almost disappeared, leaving workers with less efficient Defined Contribution (DC) Plans. Current reports also suggest that Americans are not saving enough outside of any employer sponsored plans.
Recognizing that the rules have changed is one thing, but understanding what pre-retirees need to do to secure their own retirement is yet another. Before we talk about solutions, we need to lay some groundwork with a short history lesson.
Historically, there are two great financial powers that must be equally engaged to provide a strong retirement plan. These two financial powers are found in present day public sector DB Plans.
What are these two powers? The first power is the power of interest rates/rates of return. Through the process of investing and risking one’s capital, an individual can accumulate assets and receive a compounding growth on those assets through the application of this power. Over time a sizable nest egg can be accumulated. A present day DC Plan (401k, 403b, etc..) relies on this financial power.
The second financial power is actuarial science. This power is likely less known by most pre-retirees, but is the “secret sauce” to DB Plans. Investopedia.com defines actuarial science as “a discipline that assesses financial risks in the insurance and finance fields using mathematical and statistical methods. Actuarial science applies the mathematics of probability and statistics to define, analyze and solve the financial implications of uncertain future events… Life insurance and pension plans are the two main applications of actuarial science.”
Most are unaware, but millions of Americans used to benefit from both financial powers incorporated into their long-term retirement plan by default because they had a DB pension plan. But, with the popularity of contemporary DC plans, the actuarial science power has been lost. The Employee Benefit Research Institute (ebri.org) has reported that among private sector workers who had a retirement plan in 1979, a healthy 62% were DB plans declining to only 7% in 2011.
If you know someone in the public sector with a DB Plan, then you know that upon retirement eligibility they had a choice of either a guaranteed single lifetime payout or some range of guaranteed joint survivorship payout options. These options typify the financial power of actuarial science and a concept called mortality credits.
As per AnnuityDigest.com a mortality credit is also known as a mortality yield. With a participating annuity, premiums paid by those who die earlier than expected contribute to gains of the overall pool. This provides a higher yield or credit to survivors than could be achieved through individual investments outside of the pool. The mortality credit increases significantly with age and hedges longevity risk, often creating a return that would be impossible to match in the broader financial markets.
Note to self: Get Mortality Credits!
Another compelling issue is who bears the risk of accumulation and distribution for an employee’s retirement income under a DB plan? Answer: The employer. Conversely, who bears the same risks for an employee’s retirement income under a DC plan? Answer: The employee.
Clearly, there has been a major transfer of risk and responsibility for an individual’s retirement from the employer to the employee. Much of this transfer has occurred with little employee education on how to secure a robust retirement without the financial power of actuarial science.
Since more popular DC Plans are void of any actuarial science, participants are left to an interest rate/rate of return environment only. Accordingly, retirees typically leave their assets in a fluctuating interest rate atmosphere and are therefore susceptible to withdrawal rate risk. Traditionally, if retirees withdraw only 4% of their asset balance each year they could feel confident they would not run out of money. However, Kelly Greene in a recent March 1, 2013 Wall Street Journal article titled, “Say Good-bye to the 4% Rule” noted that “In recent years, the 4% rule has been thrown into doubt.”
A January 21, 2013 research paper by MorningStar titled “Low Bond Yields and Safe Portfolio Withdrawal Rates” concluded “a 4% initial withdrawal rate has a 50% probability of success over a 30 year period.” A 50% probability of success means a 50% chance of failure! This means that my Grandfather who has been in retirement for 34 years would likely have run out of money years ago! Fortunately for him, he has a DB Plan.
A 50% chance of failure doesn’t sound like financial peace. So, what are pre-retirees to do? Can they incorporate actuarial science back into their planning? Stay tuned for a solution to this dilemma.