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Benefits and Pensions MonitorThe Debate Continues
Social security reform in the United States continues to be in the headlines. Amid all of the posturing of various interest groups comes a report from Standard & Poor’s which adds some actual information, rather than emotion, to the debate. The report is aptly called ‘Can People Save Enough?’ As the title suggests, the piece asks what should be one of the central issues in the debate. Can individuals build a nest egg large enough to provide for their retirement with a cushion against the inevitable investment risks? If they can readily build a large enough nest egg, then all other debates about risk sharing and risk transfer to the individual are moot. Save More Than You Thought Forecasting returns based on historic averages obscures the wide variability in returns over time. Instead, the report uses Monte Carlo simulations using annual data for the 60-year period from 1945 to 2004. They use a 40-year accumulation period (from age 25 to age 65) for two different investors: one who is 100 per cent invested in stocks, and one who has a 60 per cent stocks/30 per cent bonds/10 per cent cash asset allocation (which is the common strategy in Defined Benefit plans). The returns from both of these strategies, at first, seem to be appealing. The 100 per cent stock allocation would give you a return of 9.1 per cent, while the more broadly diversified strategy would give a 6.2 per cent return. But these averages obscure what may happen in specific instances. An investor who puts aside $1,000 annually over the 40 years could, depending on the year that they started, have up to $1.3 million dollars when they retired at 65 (based on the 60/30/10 split). Or, and here is the surprise, they could end up with nothing. While the average return is $175,000, two-thirds of the outcomes fall between the range of $62,000 and $285,000. For the investor who is 100 per cent invested in stocks, the return range is even larger. In the best case scenario, they could end up with $6.1 million, while in the worst they would again end up with a zero balance. The average return is again larger ($377,000), but so is the range. Two-thirds of the potential outcomes fall between $777,000 on the upside, and nothing on the downside. But accumulating assets is only half of the battle. The second phase comes during retirement, as money is withdrawn every year from the retirement fund while the remaining funds stay fully invested. Obviously, those individuals with the zero balance end up with no retirement income, but how far will the average return of $175,000, based on saving $1,000 a year, get you? The author tests this amount as well as a sum of $700,000 which would be the average return from an investor who can save four times that amount on a yearly basis. Using a retirement payout of $40,000, we find that the individual who had a $175,000 nest egg won’t be able to sustain a $40,000 a year retirement lifestyle for very long. By Year 10, the money is gone. Thriftier Saver Of course, changing some of your assumptions in the accumulation or distribution phase will alter the above findings, but that really isn’t the point. An individual earning $40,000 a year (roughly the median personal income in the U.S.) and saving 10 per cent of their earnings would, on average, build up $700,000, which is enough to fund their retirement. But there is no guarantee that even this thrifty investor could build up this size of retirement savings. Those who saved even less per year may be able to fund their retirement (remember that one lucky investor with $1,000 annual savings hit the $6.1 million mark), but this is far from assured. Letting individuals look after their savings is still valid. However, some of these individuals will be disappointed. The challenge is to help identify and compensate those who will end up losing out. Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University, in Toronto. |
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This time period includes the booms in the 1950s, 1960s, and early 1990s, as well as the 1973-74 and 2000-2002 bear markets.