EBRI: Retirement Replacement Depends on Three Factors

September 14, 2006 (PLANSPONSOR.com) - Americans who want to have the best chance of building a big enough retirement nest egg need to factor in investment and longevity risk, as well as catastrophic health care costs, according to a new study.

In a new analysis of the best way to determine an individual’s retirement replacement rate, Jack VanDerhei of Temple University asserted in a research paper published by the Employee Benefit Research Institute (EBRI) that the three-pronged calculation should render the most realistic result. The report also supports workers buying an annuity, which VanDerhei said could help make a nest egg last longer.

To help workers make the best calculation, VanDerhei also announced the planned 2007 unveiling by EBRI of its Ballpark Estimate Monte Carlo Web site with new calculators.

“The results of this model reveal, in many cases, the sobering (if not staggering) amounts of money needed to provide a reasonable high chance of being able to afford retirement,” VanDerhei wrote. “However, they also show the positive results that can be obtained by annuitizing assets in retirement to protect against the risk of longevity. In this regard, the model points not only to a more realistic size of the retirement income problem but also ways that individuals can begin to deal with it.”

However, VanDerhei admitted that, even with EBRI’s new system, there are few definite aspects of the replacement rate process.

No Correct Rate

“In reality, there is no “correct” single replacement rate,” he wrote. “Even at a specified probability of success, an “adequate” replacement rate depends dramatically on the level of retirement expenditures, retirement age, gender, asset allocation, percentage of annuitization, and other variables detailed in this Issue Brief.”

Different people with different life circumstances and retirement preferences are going to have markedly different savings targets.

“Moreover, the huge variation in the range of replacement rate targets – depending on the individual’s income, degree of annuitization for initial retirement wealth, and the asset allocation of the post-retirement investments – call into question whether the use of a single rule-of-thumb measure is realistic to use in the retirement planning process,” VanDerhei wrote. “Given the huge variation of individual circumstances (such as age, health, and income) and the complexity of retirement risks that need to be dealt with – such as longevity (addressed through annuitization of assets), old-age infirmity (addressed through long-term care insurance), and asset preservation (addressed through investment allocation) – a simple one-size-fits-all replacement rate will not work for most Americans.”

One of several scenarios treated in the research paper concerned a low-income male retiring at age 65 with no equity investments who wants a 90% chance of having enough to live on in retirement. The necessary replacement rate for this worker without an annuity would be approximately 241%. If 25% of the initial retirement wealth were annuitized immediately, the replacement rate could be reduced to approximately 213%, according to the research.

VanDerhei said that the new EBRI Web site, www.choosetosave.org , includes all three of the factors EBRI believes need to be included in the retirement replacement calculation – investment risk, longevity risk, and risk of potentially catastrophic health care costs.