Barry’s Pickings: Adequacy

Ask several retirement plan professionals, “How much income in retirement is enough?” and one may get several answers. Michael Barry, president of O3 Plan Advisory Services LLC, discusses why this is an individual decision, and what issues in the retirement plan system need to be addressed.
Art by Joe Ciardiello

Art by Joe Ciardiello

In the era before the widespread adoption of 401(k) plans, employer sponsored retirement plans were designed around a concept of adequacy that focused on a replacement ratio, generally a target percentage of preretirement income. Thus, the Aon Consulting/Georgia State University 2008 Replacement Ratio Study concluded that “[r]equired replacement ratios now range from 77 percent for a person earning $80,000 to 94 percent for a person earning $20,000.” Aon’s more recent study, 2018 Retirement Income Adequacy at U.S. Plan Sponsors, takes an account balance-based approach, finding that “[t]he average needs for full-career contributors are 16.4 times pay at retirement, or 11.1 times pay after adjusting for the expected value of Social Security at age 67.”

An idealized definition of an adequate retirement

Underlying both studies is a retirement income target “based on the idea that individuals need an income that will allow them to maintain their preretirement standard of living over a postretirement lifetime.” To its credit, Aon, in its 2018 study, considers an “alternative scenario” in which “retirees may personally choose to reduce their standard of living in retirement.” And discusses, as one possible consequence of not meeting the target, that an individual could simply choose to work longer.

On some very rough assumptions, assuming a career beginning at age 35 and retirement at age 67, an individual would have to save (annually) around 24% of pay, between their own savings and what their employer contributes, to have 11.1 times final pay.

That’s a lot of money—on top of what the employee and the employer are contributing to Social Security.

Competing needs and preferences

There are, however, a number of factors that can make these numbers problematic. Consider: it costs a middle-income family $233,610 to raise a child to 18. More (sometimes a lot more) if you’re helping your child pay for college. This cost, of course, reduces your pre-retirement consumption. Targeting replacement income for an individual with, say, three kids, may radically overestimate her post-retirement needs.

Paying off student loans, home purchase, raising and educating children, all affect the spending and saving patterns of individuals, often in very different ways.

We do have a problem with getting people to save adequately for retirement—several hundred thousand years of biology have conditioned us to underestimate the importance of the future. Indeed, at the beginning of the 20th century the life-expectancy-at-birth was less than 50 years. The need to provide for a long (possibly very long) old age—when we can’t, or really don’t want to, work—is a relatively new thing. The behavioral economists call this bias against the future “hyperbolic discounting.” As a result, we need to push against human hard-wiring to get people to save enough for retirement.

That is all true, but …

There must be more to life than saving for retirement

Some parents are not going to say to their daughter, “I’m sorry honey, I can’t pay for you to take piano lessons. I have to make sure I have 11.1 times my final pay when I’m 67.” Otherwise, the only people playing piano in the future will be rich people’s kids.

The basic insight of economics is that, under conditions of scarcity, all decisions are tradeoffs—of one preference against another. The needs of individual human beings are radically heterogeneous. So that, while we can come up with guidelines, there is in fact no one right answer as to what is “adequate” retirement savings for any given individual.

A subjective definition of an adequate retirement

All of which is prologue to what I really want to say.

Before the advent of the 401(k) plan, employer retirement plans provided a one-size-fits-all solution to the retirement savings challenge: everyone got the same benefit whether they wanted it or not. Critically, whether they wanted the benefit offered or some other more modest one plus some additional cash, say for piano lessons for their kids. Or, for that matter, to go to Venice before they got too old to walk around. And for this purpose, these plans used an objective definition of adequacy, e.g., the 77% of preretirement income target proposed by the 2008 Aon study.

The brilliance of the 401(k) system is that it allows individual employees to decide how much to save and how much to spend on other things. In doing so, the 401(k) system provides a different and radically subjective answer to the question “what are adequate retirement savings?” Under the 401(k) system, we let each individual participant decide. Indeed, unless we get revelation from some deity, there is in fact no objective answer to that question. There are only different opinions. And in the end, the 401(k) system gives the final call to the individual saver. After all, it’s his money, his individual situation—who is in a better position to weigh and choose between the tradeoffs?

This flexibility, at the individual level, of the 401(k) system is what has allowed it, in tune with the zeitgeist, to flourish. If the 20th Century was about creating wealth from scale, from a “mass” economy—where everyone (more or less) drove the same car and watched the same TV shows—the 21st Century is about the individualization of decision making, with cars built to order and a billion YouTube channels.

A new set of problems

This new and radically subjective 401(k) system presents us with a number of problems to solve.

Unlike, e.g., in a defined benefit (DB)-based system, under-saving in the 401(k) system remains a critical risk. We have developed ways—tax incentives, matching contributions and, most significantly, defaults—to get employees in employer plans to save more. We need a better understanding of whether those strategies are effectively (and efficiently) counteracting the human tendency to hyperbolically discount future needs. And we need to find ways to push these strategies out to individuals who aren’t in employer plans—the “uncovered.”

We need to understand better the role of the employer and how employers can add value to this system.

And we need a solution to the payout problem. It’s telling that, still, after nearly 40 years, we don’t have one. In this regard we are, again and indeed even more so, confronted with the problem of heterogeneity—retirees’ needs and preferences in the payout phase are an order of magnitude more heterogeneous than they are in the accumulation phase.

Some sort of pooling option—in fact a sort of “mass solution”—is clearly needed, so that each individual saver does not have to self-insure against longevity. And a way of getting those individuals who should to seriously consider taking that pooling option.

The solution to any one problem leads inevitably on to others.

But, with respect to the retirement savings meta-issue—how much is enough?—we have at least located the decision where it belongs, with the individual.


Michael Barry is president of O3 Plan Advisory Services LLC, and author of the new book, “Retirement Savings Policy: Past, Present, and Future.” He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly about retirement plan and policy issues.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.