Too gloomy a view

Posted by on August 21, 2012 @ 1:30 pm in Retirement

Retirement systems are dynamic and can be expected to change over time. But one hindrance to thinking about change is the common practice of promoting excessively gloomy views of retirement outcomes in the United States. For example, a recent New York Times op-ed suggested that “downward mobility in retirement is a looming reality for both middle- and higher-income workers,” with half of middle-class workers expected to be “poor or near poor.”

This kind of observation flies in the face of the observed facts. Federal Reserve and academic economists have estimated that 18% of Americans will live in poverty or near-poverty in retirement.* This is not half the middle class. It’s also a well-established fact that the individuals most at risk in retirement are those who have an economically difficult working life—namely, households with very low incomes. And if there’s one thing we know about retirement readiness, it’s that higher-income households are one of the groups least at risk.**

A view that’s too gloomy distracts us from a realistic understanding of the retirement savings challenge. According to two recent studies, just over half of Americans seem clearly on their way to a financially secure retirement—good news but hardly encouraging as a top-line result. Yet dig a bit deeper in the data, and you find that an additional 30% to 35% of Americans are on the path to being prepared for retirement. They need a “nudge” to save or work a bit more (or both).*** Lumping half of the population into the high-risk poverty category distracts us from the different policies that can benefit these different groups.

Another critique is that most individuals can’t be successful at saving and investment—”the retirement system simply defies human behavior.” As a result, the argument goes, a big slice of America’s retirement savings should be directed to a government-guaranteed investment option, not private markets.

I’ve spent the last decade documenting poor planning skills among segments of the saving and investing public. The central question in this behavioral economics research hasn’t been, “How can we prove that most Americans are incompetent to make decisions on their own?” Rather, the question has been, “What can we do to alter the framework (the so-called decision architecture) to improve private choices?”

This research has yielded some important insights. For example, in 401(k) plans, we know that young workers, low-income workers, and minorities often fail to save for the future, even though they believe saving is important. It’s a failure to take action. **** As a result, Congress has shifted policy to encourage automatic enrollment and automatic investment features in retirement savings plans. More workers today are on “autopilot” when it comes to their savings and investment decisions, and the trend is expected to continue to grow.

Moreover, when thinking about the U.S. retirement system, it’s critical to look at all of the pieces of the puzzle. Virtually all Americans are supported by a government-guaranteed safety net in the form of Social Security and Medicare. With meaningful government support as a “floor” of protection, the idea that households should be protected from making any risky financial decisions with a portion of their retirement portfolio seems like an extreme aversion to risk-taking. The notion that households should run from any financial risk-taking, or that they lack any ability to assume such risks, seems flawed.

In our broader lives, we make many decisions that have far-reaching consequences and so can be seen as “risky.” These include the choice of education, relationships and children, job and career, plus other consequential financial decisions like buying a home. I’d argue, for example, that the decision about whether to go to college is more economically consequential than how to invest for retirement. And most of these decisions don’t have a government safety net underlying them.

From a household’s perspective, owning private financial assets like stocks and bonds can have other benefits. It helps diversify the political risk associated with government benefit programs (in other words, the risk the government might reduce benefits), as well as the liquidity and pricing risks associated with owning a home, as I wrote about recently.

So a healthy debate about change in retirement systems is a good idea. But it’s not useful to start the debate with an excessively gloomy view of retirement outcomes or of our risk-taking and decision-making abilities.

* Love, David A., Paul A. Smith, and Lucy C. McNair, “A New Look at the Wealth Adequacy of U.S. Households,” Review of Income and Wealth 54(4), December 2008, 616–642.
** See chapters 3 and 4 of Redefining Retirement: How Will the Boomers Fare? Brigitte Madrian, Olivia S. Mitchell, and Beth J Soldo, Oxford University Press, 2007.
*** In “Retirement Savings Readiness and Retirement Savings Shortfalls for GenXers,” Employee Benefit Research Institute Notes, June 2012, 33(6), researchers find while approximately 44% of households are “at risk” at 100% of their target goal, less than 20% are “at risk” at 80% of goal. Similarly, in “National Retirement Risk Index: How Much Longer Do We Need to Work?” Center for Retirement Research at Boston College, Issue Brief 12–12, researchers note that 50% of Americans are prepared for retirement at age 65 but that rises to 85% by age 70.
**** Madrian, Brigitte C., and Dennis F. Shea, 2001, “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics 116(4): 1149–1187. And also see Choi, James J., David Laibson, Brigitte C. Madrian, and Andrew Metric, 2006, “Saving for Retirement on the Path of Least Resistance,” in Behavioral Public Finance: Toward a New Agenda, Ed McCaffrey and Joel Slemrod, editors, New York, Russell Sage Foundation, 304–351.

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