Financial Engines recently released its new study of how well American workers are doing in saving and investing for retirement. Financial Engines has access to a sample population of 2.8 million 401(k) plan participants. The firm analyzed these individual investors using a number of powerful metrics.
The high-level results of their findings are eye-opening:
1) 72% of plan participants are not on track to be able to comfortably retire at age 65
2) 39% of plan participants are not contributing enough to their plans to get the full employer matching contributions
3) 34% of plan participants have portfolios with inappropriate risk levels and/or poorly allocated portfolios
4) Of the 72% who are not on track, the typical participant is expected to be able to be able to replace 45% of their pre-retirement income, as compared to a ‘goal’ of 70%
This study has a huge sample of people–almost 3 million, which makes the results very robust. Even these numbers make the situation look better than it is. Only about 50% of workers have access to any type of retirement plan at work and, not surprisingly, those without employer-sponsored plans are evidently saving and investing less.
Financial Engines uses an approach that is quite sophisticated in looking at how well investors are allocated and how much risk they need to take on. They use Monte Carlo simulations–an approach in which many possible future market scenarios are modeled–to determine how much risk is appropriate for investors and how much return an investor can realistically achieve from his available investment choices.
One of the nice results in this study is the result that a reduction in average annual return of 0.4% per year due to either poor diversification, high expenses, or both, will lead to a 16% decline in total wealth accumulation over a 40-year career (p. 45). This result is consistent with a range of other studies.
One of the important factors that each person must think about when looking at studies like this is whether the retirement goals are like their own. Most important, do you plan to retire at age 65 and will you need 70% of your pre-retirement income in retirement. There is a rule-of-thumb that people need 70% to 80% of their pre-retirement income during retirement, including social security, but this number will obviously vary substantially. People who enter retirement with a mortgage payment and other debt will naturally need more income. The cost of supplemental health coverage beyond what is covered by Medicare can also vary and we have very little confidence in how much such coverage will cost in the future.
I would argue that studies such as this one should be the focus of substantial national attention. There are plenty of uncertainties in projections of portfolio risk and return, but the approach used by Financial Engines is well-tested and is certainly consistent with best practice.
The solutions to the retirement funding shortfalls that we currently face are, not surprisingly, to work longer, save more, and invest more intelligently. If workers do not or cannot save more during their working years and lack the expertise to build or access to well-allocated portfolios, the most likely outcome is that people will simply end up working longer than they planned or ending up with a reduced standard of living.
To get a sense of the kinds of savings that these kinds of analysis project people will need in retirement, T. Rowe Price provides a nice tool that is free, takes very little time to run, and can be run from your browser.