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The retirement problem—A Commentary by Simon Johnson and James Kwak ’11

The following commentary was published in The Washington Post on November 10, 2009.

The retirement problem
By Simon Johnson and James Kwak ’11

Correction to This Article: An earlier version of this column incorrectly relied on the Social Security Administration's online benefits calculator, which estimates future benefits in wage-indexed dollars rather than inflation-adjusted dollars. This version has been corrected.

Recent volatility in the stock market (the S&P 500 Index losing almost 50 percent of its value between September and March) has led some to question the wisdom of relying on 401(k) and other defined-contribution plans, invested largely in the stock market, for our nation's retirement security. For example, Time recently ran a cover story by Stephen Gandel entitled "Why It's Time to Retire the 401(k)."

However, the shortcomings of our current retirement "system" predate the recent fall in the markets, will not be solved by another stock market boom. The problems are more basic: we don't save enough, and we don't invest very well.

We ran several scenarios of what a typical two-adult household that entered the job market last year at age 22 might expect to receive on retirement at age 65 in 2051. For each scenario, we assumed that our household would earn the median amount for its age group every year. We began with data from the U.S. Census Bureau on 2008 earnings by age group, and assumed that real incomes would grow by 0.7 percent per year (the average growth rate for the 1967-2008 period). According to analysis by Andrew Biggs, medium earners typically accumulate Social Security benefits equivalent to 52 percent of their pre-retirement income, which comes to $40,265 per year. (All figures are in 2008 dollars.) For our scenarios, we used different estimates of the household's savings rate and of the rate of return it would earn on its savings.

For the first scenario, we assumed the average economy-wide savings rate of 2.4 percent over the last ten years (1999-2008) and a real rate of return of 6.3 percent -- the long-term average real return for the stock market. (In his book Stocks for the Long Run, Jeremy Siegel calculates the annual real rate of return from 1871 to 2006 as 6.7 percent; updating that figure through 2008, we get 6.3 percent.) At retirement, this yields accumulated savings of $298,064. Today, a 65-year old couple could convert $298,064 into a joint life annuity of $18,467 (we did an online search for annuity rates), meaning that they would receive that amount each year (not indexed for inflation, however) as long as either person were still alive. (Anything other than buying an annuity is gambling that you won't outlive your money.) $18,467 is only 24 percent of the household's income at age 64. Combined with Social Security, the couple would receive $58,732 per year, or a respectable 76 percent of its pre-retirement income of $77,432.

Savings were unusually low over the past decade. The current savings rate (first three quarters of 2009) is 3.6 percent. Plugging this into our spreadsheet, we get an annuity of $28,092 and retirement income of $68,357, or 88 percent of pre-retirement income.

But this overlooks the fact that people do not earn the rate of return of the stock market. Even assuming that people are investing in stocks, most do so via stock mutual funds which, on average, do worse than the stock market as a whole. For example, in the 1990s the average diversified stock fund had an annual return 2.4 percentage points lower than the Wilshire 5000 Index (which reflects the performance of the overall market). The main reason for this underperformance is that mutual funds have to pay fees to their managers -- who, on average, do not earn those fees through superior stock-picking (to put it mildly).

If we use a 3.9 percent annual return instead of a 6.3 percent annual return, now our annuity is only worth $15,347 per year, and combined with Social Security our household is only earning 72 percent of its pre-retirement income. But wait -- it gets worse.

The average investor in mutual funds does not even do as well as the average mutual fund. The reason is that investors tend to chase returns. They take money out of funds that have recently done badly and move it into funds that have recently done well. Because of mean reversion (the tendency for trends away from the average to return back to the average), this means they take money out of funds that are about to go up and put it into funds that are about to go down. Among large blend stock funds (the category that includes S&P 500 index funds), research from Morningstar shows that the gap between mutual fund performance and investor performance ranges from 0.9 to 2.2 percentage points, depending on fund volatility. (It can be much higher -- over 10 percentage points -- for other types of funds.)

Taking an average gap of 1.6 percentage points, our expected annual returns are now just 2.3 percent. Now our cumulative savings are only $172,853 and our annuity is only $10,709; combined with Social Security our household is only earning 66 percent of its pre-retirement income.

Now, you can get close to that 6.3 percent expected return through a simple strategy: buy a stock index fund and don't touch it. But this has another problem -- you are 100 percent invested in stocks, the riskiest of the major asset classes. Whatever your expected cumulative savings, there is a 50 percent chance that your actual savings will be lower, and they could be a lot lower.

Since we're talking about survival in old age, ideally our household would not take any risk at all. The closest you can get to this is to invest in inflation-protected Treasury bonds. 20-year TIPS (Treasury Inflation-Protected Securities) currently yield 1.96 percent on top of inflation. This provides a final annuity of $9,925; combined with Social Security, that's 65 percent of pre-retirement income. That's not very much. And the only way to get higher returns is by taking on risk.

Bear in mind that we're assuming that Social Security will be around in its current form, as will Medicare (or else seniors will have sharply higher health care costs than they do today). Also, we've made a number of optimistic assumptions along the way: that life expectancies do not increase by 2051 (this would reduce the annuity you can get with the same savings); that median-income households save money at the average rate for all households, which is untrue (richer households save at a higher rate, making the average savings rate higher than the median savings rate); and that the savings rate is constant over age (since older people in fact save at a higher rate, the money has less time to build up). In addition, we haven't started talking about below-median households, who save at a lower rate.

The problems, in short, are that we don't save enough and we don't invest very well. One could argue that these are a matter of choice. People could save more, and they could make smarter investing decisions. But given that they don't, we could very well see tens of millions of seniors without enough money to live decently in retirement. Given that prospect, perhaps we should question leaving retirement security to individual choices and free markets.

Simon Johnson is a professor at MIT Sloan and senior fellow at the Peterson Institute. James Kwak is a Yale law student and former software entrepreneur. They blog about economics at The Baseline Scenario.