U.S.: Working longer

A] Prelude

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B] The Issue

Older workers today have more wealth than previous generations but are afraid to use it. Workers covered primarily by traditional pensions that paid them a monthly check for life retired at an average age of 62, while those relying on 401(k)-style plans retired closer to 66, a new study found.

C] Switch from DB to DC

In the good old days, when my father retired, he had a traditional pension that paid him a monthly check for life. He never had to wonder whether he would outlive his income. The plan absorbed that risk. His benefit was guaranteed. The shift away from guaranteed Defined-Benefit (DB) pension plans to non guaranteed investment based 401(k) retirement plans has helped to push retirement dates later and has changed people’s mindset about leaving the workforce.

The big reason you and so many other Americans are working to age 65 and beyond is because you don’t know how long the money you’ve accumulated in your retirement accounts needs to last.

Workers covered primarily by traditional pensions that paid them a monthly check for life retired at an average age of 62, while those relying on 401(k)-style plans retired closer to 66, according to a new study titled “The Shift from Traditional Pensions to 401(k)s: Retirement Risks and the Timing of Retirement.” And the shift away from defined-benefit plans to what are broadly known as defined-contribution plans accounts for roughly 92% of the increase in people working to age 65.

Workers retire later in a 401(k)-dominated system primarily because risk shifts from employers to households – and that changes behavior, Rosemary Kaiser, an assistant professor at Rutgers University, and her co-authors found.

D] Longevity risk forces workers to take precautions

Today, most workers – including yours truly, along with some 70 million other people saving for retirement in a 401(k) plan – do not have that built-in lifetime guarantee.

Workers today accumulate a pool of assets and then must decide how fast to drain it. The problem is that no one knows how long their retirement will last. It might be a few years or a few decades. When you don’t know the length of the runway, you behave differently. You save more. You spend more cautiously. And you work longer.

“We find that while uncertain returns significantly delay retirement, longevity risk is the primary driver of welfare losses, as individuals are forced to over-save to hedge against an uncertain horizon,” the authors wrote.

In normal English, households relying on 401(k)s end up working longer and carrying more uncertainty than workers covered by traditional pensions. Even if they accumulate more wealth, which on average they do, according to the study, they experience less financial security.

E] Investment-return risk delays retirement

With a traditional defined-benefit plan, the employer absorbed the ups and downs of the market. My father never had to check the balance in his pension account or worry about whether stocks were up or down. His pension benefit was fixed. The only real concern was whether the company could continue paying the promised check.

That is not how it works with a 401(k).Under a defined-contribution plan, retirement income depends quite a bit on the value of your portfolio. And when that value fluctuates, so does your confidence about retiring.

There is another layer of risk that does not exist in a traditional pension: sequence-of-returns risk. If markets decline in the early years of retirement, withdrawals can permanently damage a portfolio’s ability to recover. A bad stretch at the wrong time can affect how long savings will last and reduce the standard of living a retiree can sustain.

That possibility alone can cause workers to stay on the job longer, waiting for markets to cooperate before stepping away.

F] No clear timeline for retirement

Another reason people are staying on the job longer: Workers enrolled in a 401(k) plan typically have no motivation to retire at a certain age. Traditional pensions were typically structured with strong incentives to retire at specific ages. That’s not the case with 401(k) plans.

In their model simulations, the authors found that workers in 401(k)-style plans arrive at age 65 with dramatically greater private financial assets – roughly three to five times as much nonpension wealth as workers covered by traditional pensions.

But even with that larger nest egg, they still retire later and experience lower lifetime welfare because – as noted above – they must manage longevity and market risk themselves.

G] Finally: Annuity as answer?

How might workers saving for retirement in a 401(k) better manage and mitigate those risks? The authors argue that giving retirees access to actuarially fair annuities – products that convert savings into guaranteed lifetime income – would significantly reduce the financial stress created by 401(k)s.

An actuarially fair annuity is a lifetime income product priced so that, on average, the present value of the payments you receive equals the amount you pay for it, based on life expectancy and interest rates.