Two Self-Evident Steps to Retire with Dignity

• Most 401k plans have several features that encourage savings. That’s the first step toward retirement with dignity.
• The 2nd step is missing because target date funds do not protect the savings of those near retirement.
• Retirement with dignity could become a legitimate goal, but it will require a significant change.

There is a “retirement crisis” in the United States, and 70% of current retirees have saved less than $300,000. They have not saved “enough” by most standards. Not much can change this for these 55 million people, but the 401(k) industry is trying to encourage savings for current participants.

Saving enough is the first step toward retirement with dignity. The second critical step is to protect lifetime savings against losses. Both are essential. This article discusses the retirement industry’s efforts to provide retirement with dignity.

Saving enough

Participants need to contribute enough and earn a good return to save enough.

Contributions

Savings are encouraged in four ways:

• Auto-enrollment
• Auto escalation
• Education
• Contribution matches

Participants are encouraged to save early in life and to contribute generously. They are given tools like this DOL calculator to determine how much they need to contribute to support a desired retirement spending level.

This video interview discusses the savings amount needed to retire with dignity. A rule of thumb is that you need to save 22 times your desired spending; for example, $2.2 million supports $100,000 per year. A typical participant will want to save 10-15% of pay in a 401(k) plan and start saving while young.

Of course, as discussed in the next section, you want to earn a decent return on your contributions.

Importance of investments

In the hierarchy of what matters most, savings rank above returns on savings. Savings make you rich. Protecting those savings keeps you rich—returns on savings help but not as much as commonly believed.

The importance of investment performance is more nuanced than a straightforward win or lose relative to savings. Performance matters most in the early years because there is more time for compounding.

The following table produced by Professor Craig Israelsen shows that savings play a critical role as we age. The older we get, the more essential savings become and returns become less critical because there’s less time for them to compound.

Most of us don’t save much when we’re young. Saving early is smart but uncommon. Retirement starts to become real as we age. As the table shows, our savings rate is the critical factor at the time that most of us begin saving in earnest for retirement later in life. Returns matter less until we stop saving —at retirement—at which time protection is critical.

As savings end and we move from working life to retirement, protecting those savings is imperative for retirement with dignity.

Risk might help you become rich as you accumulate wealth but protecting wealth at its peak keeps you rich.

Designers of target date funds (TDFs) argue that participants can and should compensate for inadequate savings by earning higher returns on those savings—by taking risk. But an SEC report on “Perspectives on Retirement Readiness” says the solution is not to increase investment risk. Instead, the answer is modifying behavior by encouraging participants to save more. Plan designers do this with the four plan features at the top of this section.

The next step is protecting savings from losses. The retirement industry needs to get better at this.

Protection against loss: This second critical step is missing

Retirement researchers have identified two interrelated concepts—“Sequence of Return Risk” and the “Risk Zone.” Losses suffered in the five years before and after retirement (the Risk Zone) can undermine retirement with dignity. Because losses matter most in this period, it’s called Sequence of Return Risk; it might also be called “Risk of Ruin.” In the absence of cash flows, return sequence doesn’t matter, but withdrawals in retirement make early returns more important.

Most TDFs ignore these risks of loss by being 85% risky in the Risk Zone, with 50% in equities and 35% in risky long-term bonds. T. Rowe Price, one of the Big 3 TDF providers, defends this practice in their Target Date Investing: A Different Perspective on Sequence-of-Returns Risk Around Retirement. November 2018

T Rowe argues that participants can afford risk near retirement because they are wealthier for taking risk over their savings lifetime — their cumulative returns leading up to retirement are expected to be high. But TDF participants do not earn the returns reported by fund companies.

Fund companies report what is known as time-weighted returns, but participants earn completely different dollar-weighted returns, the correct measure of wealth accumulation. As the name implies, dollar-weighted returns give weight to the money invested when the return is earned – the greater the value of assets, the greater the importance of the return on those assets. Dollar-weighted returns are impacted most near retirement because that’s when wealth is the greatest.

Time-weighted returns eliminate the effects of savings, so they are the same for all participants. By contrast, each participant has a unique dollar-weighted return that reflects the amount and pattern of individual savings.

There are as many dollar-weighted returns as there are participants, and savings are the dominant factor in creating that individual wealth. Generalizations about risk and return are specious because it’s mainly about the amounts and timing of contributions. It’s complicated.

Reporting dollar-weighted returns would help participants evaluate their saving progress. Have contributions been made at beneficial times or harmful times on average? It’s mostly luck, of course, but an important insight because it’s the part of the performance puzzle that participants own. 

Each participant must protect their savings as they near retirement to retire with dignity. As we approach retirement, we plan for the decades ahead without paychecks. Whatever we’ve saved has to be “enough” because that’s all there is. Losses to “enough” require changes to our plans that could sacrifice dignity.

In retirement

You want to approach retirement with savings protected, but because safe assets currently earn low returns, you’ll want to re-risk in retirement. An optimal post-retirement glidepath is provided by the research of Dr. Wade Pfau and Michael Kitces in their Reducing Retirement Risk with a Rising Equity Glide Path. 

Pfau and Kitces find that the optimal glidepath in retirement starts at 10-20% in equities and re-risks during the ensuing 30 years to 40-50% equities. The safe starting point defends against the Sequence of Return Risk, and the re-risking extends the life of assets, increasing the odds of lasting a lifetime. 

Beginning retirement at 10-20% equities means we need to end our working life at 10-20%. This leads to a U-shaped glidepath like the patented path shown in the following graph.

In the jargon of TDFs, this U-shape is both a “To” fund and a “Through” fund. It’s “To” because it reaches its lowest equity allocation at the target date, and it’s ‘Through” because it serves through to death.

Conclusion

The prescription for retirement with dignity is simple: (1) save enough and (2) don’t lose those savings. Like the police motto “Serve and protect,” the retirement investor motto is “Save and protect.” Risking lifetime savings in the Risk Zone is a bad gamble, even though it has paid off over the past decade. The “Roaring 2010s” have set the stage for the “Depressing 2020s.”

The TDF industry is taking a lot of risk for those near retirement. The wisdom of that bet is changing. Interest rates are going up, and stock market bubbles are bursting. We will see a repeat of the 2008 disastrous losses, and this time it will be worse because bonds no longer defend, and TDFs are now $3.5 trillion versus $200 billion in 2008.

There are a few TDFs that defend at the target date. The most notable is the $800 billion Federal Thrift Savings Plan (TSP). It is 70% safe at the target date in the government-guaranteed G fund. Another example is the Office and Professional Employees International Union (OPEIU), one of the largest AFL-CIO unions ( the author manages this).

There are two distinct TDF designs with materially different objectives. Some say fiduciaries don’t know or care about TDF risk. That will change. Let the lessons begin.

Ron Surz is President of Target Date Solutions, a DBA of PPCA inc. He is also the author of Baby Boomer Investing in the Perilous Decade of the 2020s. He can be reached at Ron@TargetDateSolutions.com.