Focusing on Measuring Benefits Adequacy: New insights for actuaries

By Vickie Bajtelsmit, Anna Rappaport, and LeAndra Foster

Introduction

A key role for pension actuaries is helping employers design and manage employee benefits. Actuaries help plan sponsors think about the balance between appealing to employees and meeting their needs with corporate cost and risk management. A key challenge is to help stakeholders determine whether projected benefits will be adequate to meet future retirement income needs. Pension actuaries often find that they are heavily focused on cost and risk issues. However, an additional and important role for the actuary is to encourage clients to consider the benefit delivery side of the equation. A new Society of Actuaries study provides unique insights into retirement benefit adequacy.

This SOA-sponsored research study focuses on measuring retirement benefit adequacy in light of both expected and unexpected expenses in retirement and linking the measurement to the needs and objectives of different stakeholder groups. The study begins with a conceptual discussion of benefit adequacy and the various ways it has been and can be measured. It then develops a simulation model that allows for quantitative analysis of retirement income adequacy and tests several scenarios for improving retirement outcomes.

The study describes three different approaches to measuring benefit adequacy, looks at each from diverse stakeholders’ perspectives, and considers their uses and limitations. Adequacy measures examined include replacement ratios, projected expenditures, and minimum societal standards. Both income needs and lump sum equivalents are considered. Different measures are better suited to the needs of different stakeholders and at different life stages. Actuaries may find that the discussion of suitability of each method for different stakeholders will be very helpful. This is a topic for further discussion within the profession.

Methods of Measuring Adequacy

The three methods are:

• Replacement Ratio – this is most often used by actuaries to help plan sponsors understand plan design alternatives and how they affect groups of individuals, but also for plan sponsors to compare their plans to those of other employers. This is also a useful method for policyholders. This method has limitations when used by individuals. The study includes a discussion of the Aon /Georgia State Study, which is widely used and recognized in the United States.
• Minimum Needs Measure – this is generally used by policymakers. The study uses the Elder Economic Security Standard TM Index (Elder Index) to outline national averages for minimum needs for various household types and specific geographic areas. This measure can help actuaries to understand whether what is provided supports a minimum standard of living. If an individual’s resources do not meet the index standard, they cannot afford to retire without significant financial deprivation.
• Cash Flow Analysis – a detailed, personalized cash flow forecast is the best way for individuals to prepare for and manage their retirement needs. This approach would normally not be directly used by those preparing approaches to work for groups of individuals but it might be embedded in education or tools offered to individuals. Financial planners and advisors would often use this approach.

Research Approach and Findings

This SOA research focuses on measuring retirement benefit adequacy in light of both expected and unexpected expenses in retirement and linking the measurement to the needs and objectives of different stakeholder groups. The report begins with a conceptual discussion of benefit adequacy and the various ways it has been and can be measured. Adequacy measures examined include replacement ratios, projected expenditures, and minimum societal standards. Both income needs and lump sum equivalents are considered. Different measures are better suited to the needs of different stakeholders and at different life stages. Under each of these methods of defining adequacy, there are similar issues in converting income needs to “a number,” the lump sum needed to fund the required income.

To investigate the impact of various risks on retiree welfare, the researchers develop a simulation model of retirement spending, incorporating standard of living goals as well as investment, inflation, life, health, and long-term care risks, with distributional assumptions for each random variable. This approach is different from the approaches commonly used today in that it more realistically considers the combined impact of many of the risk factors faced by retirees. Most stochastic approaches focus on investment and inflation risks and do not model uncertain cash flows stochastically. In thinking about results, it is critical to understand what has been treated on a stochastic basis. The SOA research study is a theoretical evaluation, but the ideas presented should be helpful to actuaries working with different stakeholders in helping them think about how to unify thinking about retirement risks and their impact on retirement security.

The median American married couple at retirement earns approximately $60,000 a year and has approximately $100,000 in non-housing wealth (based on the 2010 Survey of Consumer Finances, adjusted for wage inflation and recent market performance). For this couple, the model shows there is a 29 percent chance median households will have positive wealth at death. The assets needed to meet cash flow needs 50 percent of the time would be approximately $170,000 compared to approximately $685,000 for a 95 percent success rate. In addition to the base case household, the study presents results for five alternative income and wealth combinations. The other two income levels represent the 50th and 90th percentiles of income.

To consider the effect of risk-mitigating household decisions, the researchers also tested several common retiree decisions that are expected to impact adequacy, including reducing the post-retirement standard of living, buying an annuity, buying long-term care insurance, delayed and early retirement, and the decision to pay off a home mortgage prior to retirement. The results include the probability of having remaining wealth at death, and its amount, as well as the number of years income is insufficient and the amount of wealth that would have been sufficient to meet needs.

Some Interesting Issues

The findings and research include some results that are expected and some that may not be expected. The study confirms that many of the next generation of retirees may face a significant drop in their standard of living when they retire. As shown in other studies, it also confirms the importance of retirement age and delaying retirement.

Other findings may be more surprising. Retirement planning often focuses on investment and inflation risk components, particularly in the wake of the recent financial crisis. However, the study shows that low probability health and long-term care shocks have a much larger potential to derail retirement plans, especially for low to median income/wealth households. Retirement savings and decumulation recommendations are often based on strategies that will be successful “on average.” The tendency to focus on averages is problematic because it ignores or disguises the impact of shock events, such as unexpected health and long-term care costs. The best strategies to preserve assets without shocks may not be the best strategies once shock events are considered. One of the most important issues raised by the study is the extreme difference between the median (50th percentile) and worst or best case scenarios (95th percentile). These differences illustrate the problems associated with focusing on averages. In the base case studies, even if retiree households have sufficient income to meet their needs on average, there is still at least a 5 percent risk that they will have a long period of shortfall (9 to 24 years, depending on wealth and income). Although not apparent from the tables shown in the report , extreme tail risks, such as early onset long-term care needs, investment declines (particularly in the early years of retirement), inflation risk, and unexpected health costs all contribute to the likelihood of retirement income inadequacy. Not surprisingly, higher wealth at retirement improves the odds of making it through retirement without financial difficulties.

Retirement planning needs to continue after retirement as situations change. Individuals should also take a "holistic" approach that incorporates the interactions between various decisions and events. There is a huge opportunity for financial service companies and employers to help their customers and employees think about sensible planning and to offer planning support. SOA research has shown that the middle market is underserved when it comes to planning. Two of the biggest challenges for planning are understanding shock events and incorporating multiple types of shocks in a “holistic” plan. For example, actuaries will want to consider that benefits provided by the employer may protect against some shocks, and the employer may be able to offer employees and retirees access to risk protection products that are paid for by the employee. Through the group insurance mechanism, employers may be able to provide employees with access to better products at more favorable prices than they can buy on their own.

Other SOA research has shown that cutting spending is a popular risk management strategy both chosen by and recommended for retirees and those nearing retirement. This study shows that moderate and higher income households can successfully retire with 20 percent less savings if they are willing to cut their discretionary spending by 15 percent. But reduced spending does not significantly reduce the impact of depleting assets for the median family because shocks are the major driver of asset depletion.

The End of the Story or the Beginning of More Explorations?

The most important contributions of this study are 1) demonstrating the importance of integrating a variety of shocks in retirement needs forecasts and 2) quantifying the difference between retirement plans that work “on average” versus those that work most of the time. The researchers considered several different combinations of retirement and risk mitigating decisions in order to compare outcomes, but the results still leave many questions unanswered. The authors suggest a number of areas for further exploration. Future research may include refining the scenarios, adding more scenarios, and looking at additional combinations of retirement decisions. The report identifies a number of areas for further research. Of particular interest is further refinement of the stochastic risk assumptions and exploring alternatives with regard to retirement timing and benefit claiming decisions. The study also looked very briefly at annuitization, and there is an area for important further research. Long-term care and health cost management strategies are also important areas for research. The study raises questions about protecting against shocks vs. longevity risk. Although the model is not intended as a planning tool to be used by individuals and planners, the ideas presented should provide “seeds” for the development of tools and for further research.

Conclusions

Actuaries focus on adequacy to help those they work with design benefit programs, financial and planning products. Some actuaries directly advise individuals. This study shows that some of the most important decisions that employees make are when they retire and when they claim Social Security. It also shows that shock events are very important and that risk management is important. It makes clear that planning that is heavily focused on investment management and the pre-retirement period does only a small part of the total job. It encourages actuaries to move beyond conventional wisdom and think about how the interaction of different factors may lead them to new conclusions and approaches.

Vickie Bajtelsmit, Ph.D., J.D. is professor of finance at Colorado State University. She can be reached at Vickie.Bajtelsmit@colostate.edu.

Anna M. Rappaport, FSA, MAAA, is an internationally known expert on retirement strategy and frequent author and speaker. She chairs the SOA Committee on Post Retirement Needs and Risks. She is the president of Anna Rappaport Consulting and can be reached at anna@annarappaport.com.

LeAndra Foster, ASA, is the vice president of client development for Della Parola Capital Management in Fort Collins, Colo. and an adjunct professor of Finance at Colorado State University. She can be reached at leandra.foster@gmail.com.