A Call for Changes in Retirement Policies and Solutions

A new report says that although the trend toward greater individual responsibility for retirement security will undoubtedly continue, there is much that employers, financial institutions, and the government can do to modernize their retirement policies and solutions in order to help Americans achieve a secure and dignified retirement.

The McKinsey & Co. study debuts a “Retirement Readiness Index” which finds that the average American family faces a 37% shortfall in the income they will need in retirement–a savings gap of $250,000 per household at the time of retirement–taking into account expected payouts of Social Security and pensions, as well as personal savings including 401(k) and other retirement plans. While middle and lower income households are least prepared, most Americans – even middle to higher income households–will fall well short of their retirement expectations, according to the study report.

McKinsey’s analysis indicates that a consistent focus on four policy principles could enable the average American family to reduce their retirement readiness gap by nearly half, injecting over $3.5 trillion in incremental assets into the retirement system over the next decade.

The four principles are:

  • Improving the accessibility of retirement plans,
  • Increasing plan participation and savings rates for all Americans, especially lower and middle income households,
  • Helping Americans to better manage their in-retirement risks in order to draw a stable “retirement paycheck,” and
  • Enabling Americans to work longer.

According to the report, 40 million American households do not have access to a workplace retirement savings plan – in most cases because the employer, often a small business, finds it too costly and administratively cumbersome to provide a plan to employees. These households could turn to IRAs to prepare for their retirement; however, fewer than 20% do.

The report says access to workplace retirement plans is an important driver of retirement preparedness. While the average American household with access to a DC plan will have about 70% of the income required for retirement, a similar household  without access will have to live on approximately 55% of the required income – and the gap only increases for lower income households.

The McKinsey study contends that with the right encouragement, the access problem could be solved. Although creating incentives for smaller businesses to provide broader access to retirement plans is important, universal coverage through a vehicle such as an auto-IRA would be most impactful, the report suggests. In addition, adding auto features that default individuals to contribute to their IRAs every year would have a tremendous impact, especially for lower income households.

“Over one- third of households with access to a qualified retirement plan do not take advantage of it, and those who do participate – including the relatively affluent – do not contribute nearly enough,” the McKinsey report contends.

The Pension Protection Act was a first step toward increasing participation and savings rates in retirement savings plans by including auto-enrollment as a condition for fiduciary safe harbor. However, the report says further steps must be taken to ensure appropriate savings rates and reduce leakage, such as revising the default rate for automatic deferrals upward and implementing auto-escalation of deferral rates.

Managing In-Retirement Risks

The McKinsey report points out that the aging American population is facing more in-retirement risks - market and inflation risks, longevity, and health issues - than in the past, and most Americans do not adequately take these risks into account when planning for retirement. Appropriate asset allocation, taking into account each household's retirement risks, would go a long way toward hedging against these risks.

The report contends that most Americans lack the financial sophistication to fully understand the risks they face and to select financial products that can adequately protect them, so improving American household retirement preparedness will require education and advice regarding these risks as well as innovative solutions to hedge them.

Finally, the report notes that millions of American households nearing retirement are running out of time to fill their savings gap, and low-income households regardless of age realistically lack the disposable income to sufficiently raise their savings rate. Many will need to work longer and many of those already in retirement will need to return to work.

The study shows that postponing retirement by four years increases an individual's "Retirement Readiness Index" by 23 points.

Barriers to keeping or getting older Americans in the workforce that need to be eliminated include Social Security’s early eligibility age of 62, which the report says serves as a signal to stop working and start collecting benefits; incentives in DB plans and provisions restricting DB payments to active workers, which discourage retirees from continuing to work; and higher health care costs for older workers, which have discouraged employers from hiring and retaining these employees.

The report is being released by the Financial Services Roundtable, http://www.fsround.org.