Stacy Schaus, Ying Gao
This article originally appeared in PROJECT M, Allianz’s award-winning magazine for the investment, retirement
and insurance markets.
The single most vexing question today concerning retirement is, how much money will I need? It is vexing because there is no simple answer. The amount any
one individual will require is determined by a host of factors, including that most unknowable of all: how long that person will live. Interest rates
prevailing at the time of retirement – a date that can be decades into the future – is another deciding factor.
Given such uncertainties, approaches to retirement planning now shun the concept of a specific “amount.” Instead, the focus is on creating an income stream
sufficient to maintain the individual’s lifestyle in retirement, but again the question arises: how much should this target income be?
Several factors influence this, not least social security. Public pension income is the first building block in real retirement income replacement. Today,
U.S. social security provides 35% of retirees’ income, but this varies dramatically from country to country. Other considerations include the availability of
a defined benefit (DB) plan, the worker’s salary, home ownership, the tenure of employment and assumed retirement age.
Retiree medical cost coverage is also a significant factor. While workers outside the U.S. are far more likely to have retiree medical coverage via the
government, only a small percentage of U.S. private employers cover retiree medical costs and this number continues to decline.
Given that the majority of employees in the United States lack both a DB and a retiree medical plan, what is the total replacement rate of the final salary
that the median American worker should aim for? Experts consulted in the DC Consulting Support and Trends Survey (2016) on average suggested 80%, which
means 40–45% needs to come from other sources such as savings, DB plans or housing.
Would a 65-year-old who has $400,000 in defined contribution (DC) assets have enough to deliver an adequate income in retirement? One way to answer this is
to look at the income that could be delivered by an annuity. Based on average annuity quotes between March 2013 and December 2015, the employee would have
received an annuity payout equal to a 6.5% to 7.2% return, providing an annual income of $25,899 to $28,665 a year. If we assume final pay was $75,000, the
income replacement would be 35% to 38%, depending on the year of retirement.
But what if the employee wanted to actually purchase an annuity in which the payout is adjusted annually consistent with the Consumer Price Index? Over the
period, real annuity quotes averaged 72% of the nominal payout. This would have delivered $17,885 to $20,501 a year, or 4.5% to 5.1% annually, in real
terms. The real income replacement rate would then equal 24% to 27% of final salary.
This is a snapshot of the past. To consider the future, a proxy is needed for annuity pricing. One methodology is the PIMCO Retirement Income Cost Estimate
(PRICE). This is calculated as the discounted present value of a 20-year annual income stream using the historical zero-coupon U.S. Treasury
Inflation-Protected Securities (TIPS) yield curve. Analysis found that a 20-year ladder of zero-coupon TIPS provides the best available proxy for annuity
So, how much do people need for retirement? Using PRICE, Figure 1 shows the cost of retirement based on a participant’s age, assumed retirement at age 65
and desired annual income stream as of December 2015. For a 25-year-old to buy an annual CPI-adjusted income stream of $50,000, the cost would have been
$530,000. In contrast, it would have cost those aged 45 or 65 about $685,000 and just over $900,000, respectively. The closer a participant is to
retirement, the higher the retirement cost.
Some plan participants may flip the “What’s my number?” question and ask, “How much income can I buy given my current savings?” Similarly, plan fiduciaries
may consider what percentage of income can be replaced based on the median balance in their DC plan. The PRICE multiplier, the cost of one dollar of annual
retirement income, can give insights to these questions. Figure 2 shows how much income (and what replacement rate) various levels of savings could provide
as of December 2015. For a 65-year-old with $500,000, the multiplier is 18.15, leading to a projected annual income of about $27,500 – or a 37% income
replacement rate, assuming the final pay is $75,000. If the accumulated balance increases to $700,000, income replacement increases to 51%.
Having identified PRICE as a proxy for the historic and future cost of retirement, it is possible to answer the “how much” question in terms of the
liability the plan member faces. Now the task of evaluating assets and asset allocation structures begins.
PRICE tells us the cost of the liability, so if we look at asset classes, we can determine which ones correlate best. Unlike a DB plan, DC plans are
unlikely to fully match the assets to the liabilities. In other words, DC plan fiduciaries would not buy only TIPS but would likely include assets that
offer additional return and accept the risk relative to PRICE.
As with reaching any goal, a concrete objective can be helpful. Although it is a theoretical construct, not a prediction or projection of investment
return, PRICE can help. It translates accumulated account balances into future retirement income potential, increasing the likelihood that individuals will
meet their retirement income goals.
This is an edited extract from the forthcoming book Successful Defined Contribution Investment Design: How to Align Target-Date, Core and Income Strategies
to the PRICE of Retirement.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No representation is being made that the stated results will be achieved. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2016, PIMCO.
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