GUEST COMMENTARY: 6 percent annually in 401(k) isn't enough

2013-01-15T00:00:00Z GUEST COMMENTARY: 6 percent annually in 401(k) isn't enoughBy Terry Zivney
January 15, 2013 12:00 am  • 

The three-legged stool of retirement planning is collapsing.

Modern workers have long depended upon Social Security, employer-based pension plans and personal savings to support them in retirement. Surprisingly, it is not an impending Social Security crisis but the replacement of traditional pension plans with 401(k)s that is the biggest problem for funding retirement. Too many workers rely upon the mistaken belief that contributing 6 percent of their salaries annually to a 401(k) is prudent planning.

For many, the 6 percent contribution is achieved by reducing the personal savings that was previously intended as the third leg of the stool. Furthermore, the 6 percent (or 9 percent, including the typical, but not assured, employer match) contribution rate most frequently chosen by 401(k) participants is insufficient to ensure viability of the middle leg of the three-legged stool.

The Wisconsin Retirement System, the only fully funded public plan in the nation, has had an average annual contribution rate of 10.5 percent over the past 20 years and will require a contribution rate of 13.3 percent in 2013 to remain fully funded. But 401(k) and other individual retirement plans face two additional risks that traditional plans such as Wisconsin’s don’t face.

There is the risk that an individual retiree might live longer than expected. A pension pool with many participants can be quite certain of the number of people living to any given age so that this longevity risk is minimal.

The second additional risk faced by 401(k) participants is investment risk. If a traditional plan earns less than projected, the shortfall can be made up in future years because there are always new workers and additional contributions coming into the system. No so for individual workers.

The first of these additional risks (outliving resources) could be reduced if workers annuitized their savings. However, the historically low interest rates in recent years and for the foreseeable future mean workers must have accumulated much more savings than previously thought necessary. The second risk, investment, can only be reduced by contributing extraordinarily large amounts.

Individuals must expect to contribute substantially more to their 401(k) plans than their employers did to defined benefit pension plans to achieve the same results.

Here at Ball State, I am leading research into the appropriate contribution rate for 401(k) plans. We found that, assuming investment securities have the same distribution of returns as occurred during the past 85 years, 23 percent of the time a contribution rate of 10 percent would fail to replace half of a person’s pre-retirement income for the average retirement life expectancy of 18 years.

At the same time, one in four married couples in retirement will have at least one member live beyond age 90. If the worker faithfully contributes 10 percent of income during the working career, 57 percent of the time this would fail to provide adequate support if retirement lasts 30 years.

Many market savants note that the investment experience of the past 85 years should not be expected to be repeated. If the actual returns going forward are just 1 percent per year less than the historical norms, then an annual contribution of 10 percent would be sufficient to fund the average single life expectancy of 18 years just about 44 percent of the time. 

A planned contribution expected with a success rate of 44 percent under a plausible scenario is clearly inadequate. Focusing on the needs of 44 percent of the people is bad business. It is even worse financial planning.

Terry Zivney is the Maxon distinguished professor of finance at Ball State University. The opinion is the writer's.

Copyright 2014 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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