The views presented here do not necessarily represent those of Advisor Perspectives.
A decade ago, James Russell, a sociologist at Eastern Connecticut State University, thought his approaching retirement was well funded. The retirement system for Connecticut educators, like many, is two-tiered, with both traditional defined benefit (DB) pension and defined contribution (DC) 401(a) schemes, the latter similar to ubiquitous private sector 401(k) plans.
Mr. Russell, a habitual saver, who contributed regularly to the 401(a) plan and adhered to an age-appropriate asset allocation, thought his account balance appeared healthy enough.
Then, as sociologists are wont to do, he did some math. To his alarm he found that his plan savings, combined with his Social Security, would replace slightly less than half of his final salary.
Mr. Russell didn’t take his discovery lying down; over the next few years he fashioned his Connecticut Committee for Equity in Retirement into a movement powerful enough to force the state to allow DC participants to equitably buy into the DB plan, an epic struggle he chronicled in Social Insecurity: 401(k)s and the Retirement Crisis.
Mr. Russell wasn’t alone in his consternation. According to data from the Employee Benefit Research Institute (EBRI), at the end of 2022 the mean 401(k) balance for participants over age 60 with more than 30 years participation — a fair approximation of someone who has participated in a single DC plan, or multiple rolled-over plans, over their working life — was $312,000. The key word in the above sentence is mean, the arithmetic average.
Unfortunately, EBRI doesn’t report the more relevant median number by age, but as a rule of thumb, the median value of retirement balances is about a third of the mean—i.e., roughly $100,000— a value in line with data from both Fidelity and Vanguard. Applying the “four percent rule” to this pitifully small nest egg allows for $4,000 of annual retirement consumption. Don’t spend it all in one place.
‘At Risk’ Retirements a Major Concern
These results align with those from Boston College’s Center for Retirement Research on the percentage of workers with “at-risk” retirements. Their latest report does show a modest decrease in this percentage over the past decade, from 51% in 2013 to 39% in 2022, but this “improvement” results from two things. The first reason for the decrease in at-risk retirements is high returns in the securities markets since 2013. The second reason is an artifact of their methodology, which adopts two strong assumptions: that retirees annuitize their nest eggs and that they also reverse mortgage their home, the latter benefitting from a decade of increasingly frothy house prices. Absent the sunny assumptions of annuitization and reverse mortgaging, the percent of at-risk retirements would be far higher.
The last piece of the DC puzzle is the widely quoted recent work of Anarkulova, Cederburg and O’Doherty, which deploys international stock data going as far back as 1890; these authors argue that to minimize the chance of outliving the nest egg, the 401(k) saver must hold an all-stock portfolio for all of life.
In their model, bonds have no role at any point in the lifecycle, except perhaps for a brief period early in retirement, and then only in a small amount. (Even more jarringly, they find a 67% allocation to foreign stocks to be optimal, though this is largely an artifact of their bootstrap methodology, which is blind to the nationality of the investor; most foreign investors, after all, would have benefitted from a U.S. stock allocation, which from their perspective is an international holding.)
Are DC Plans All That Great?
Considering all of the above, we decided to explore two questions: First, just how well have the market gods smiled on DC plan participants in the 401(k) era, which began in 1978? This is simply another way of asking how well they’re liable to do going forward. In order to answer this question, we examined how well hypothetical DC participants would have done before 1978, starting as far back as 1871. It turns out that the 1970s were a good time to begin a DC retirement scheme, and that it’s optimistic, in the extreme, to take the sunny experience of the past half century as predictive of how future participants will fare.
Second, is the bond skepticism of Anarkulova et al., which runs counter to the accepted life-cycle wisdom, warranted? To our considerable surprise, we find ourselves in agreement: The addition of bonds to a retirement portfolio increases, not decreases, the odds of failure.
Let’s start with a simple assumption of a 30-year working career, during which the saver invests in a portfolio dominated by risky assets, followed by a 30-year retirement during which she invests in safe assets. The below table deploys a simple straight-line amortization formula to compute the rate of return necessary during the 30-year working career to fund retirement at various savings rates and at various risk-free rates during retirement:
The first row, for example, examines a 10% savings rate; the worker with an inflation-adjusted $6,000 monthly salary saves $600 per month, leaving a real $5,400 for consumption. In order to have enough assets to maintain that $5,400 monthly spending in retirement, she must earn an 11.7% real return during accumulation if her retirement portfolio is used to purchase a TIPS ladder yielding 0%; if she is lucky enough to earn the current 2% TIPS yield in retirement, this required portfolio real return falls only slightly, to 10.4%.
Good luck with that. Not until her savings rate rises into the 25%–33% range do her required rates of return start to look even halfway reasonable.
Admittedly, the amortization calculation used above is a bit of a cartoon. Returns sequence matters: the saver devoutly desires a concave returns sequence, with low returns early in the savings phase followed by higher returns later on, which reduces the required rate of return. This is precisely the sequence that blessed those who began their careers in the 1970s. On the other hand, a convex returns sequence, with high returns followed by low ones, increases the required rate of return. (Returns early this century may well prove to be convex; if so, it will work to the detriment of current workers.)
Back in the real world, we simulated how a 100% stock portfolio would have done over overlapping successive 30-year savings sequences beginning in 1871, using the Shiller return series.
Grim indeed: using historical data, our analysis shows that not until the savings rate approaches 25% does the saver have more than a 50/50 chance of success, and to approach certainty requires savings rates in the 40% range. Lower savings rates require a market return that has seldom been on offer.
The Dubious Role of Bonds
Does adding bonds help by smoothing out the ride? No. When we lower the stock allocation during the 30-year accumulation phase, the odds of retirement success deteriorate and the required savings rate increases. It turns out, counterintuitively, that only one maneuver improves the success rate, and that’s a 100% stock portfolio both during accumulation and retirement. With overlapping 60-year sequences invested 100% in stocks, for all of life, here’s what the success rate looks like:
Although our methodologies differ, we arrive at the same conclusion as Anarkulova et al. Most authorities recommend a savings rate of around 15%. Note, however, that the above table shows that with a 15% savings rate, even an all-stock-all-the-time portfolio succeeded only 62% of the time, dominated by the last half-century’s low interest rates, high security returns, and prosperous and peaceful free-trade-oriented world order.
This was likely an aberration; our analysis — as well as that of Anarkulova et al — suggests that if today’s workers want a better than even chance of successfully maintaining their pre-retirement consumption level at a mere 15% savings rate, they’re likely going to have to endure a 60-year white-knuckle ride at 100% stocks. Contrariwise, the conventional alternative — a target-date fund with a typical glide slope—likely requires savings rates north of 25%.
It's important to point out that the Hobson’s choice between an insanely high savings rate and an insanely risky portfolio implied by us and by Anarkulova et al. doesn’t apply to everyone, only to the median worker. If you’ve accumulated enough to see your retirement through with safe assets — say a TIPS ladder and/or an annuity — then God bless. Chances are you got there with some combination of aggressive saving, high risk tolerance, and steely discipline — or at least carefully chosen parents. You’re certainly going to sleep better than most people.
Alternative Solutions
The obvious alternative to this parlous state of affairs involves the risk sharing available in DB pension plans; in the DC environment, this can be approximated by annuitization, which we’ll examine in future work. Annuitization holds out that hope that a constant income stream at an initially lower cost than an inflation-adjusted bond portfolio may save retirees. It should be noted, however, that commercial annuities expose the retiree to both inflation risk and credit risk. In addition, annuities vaporize a source of emergency funds and expose the retiree to the money illusion — an initially appealing nominal payout that inexorably corrodes with the passage of time.
The current system doesn’t need more nudges; it needs dynamite and rebuilding from the ground up on the DB model. Social Security is a good place to start. While its funding stream needs repair, from the beneficiary’s perspective, it remains the gold-standard DB model, with inflation-adjusted payouts, near-zero credit risk, and administrative expenses of around 0.6%. The beneficiary who begins payments at age 62 in order to invest in stocks and bonds is most likely making a foolish mistake, and, as Chile has learned to its chagrin (and the U.S. will soon enough), so too is the nation that privatizes its social insurance.
Memo to advisors: don’t allow your middle-aged clients depending on their 401(k) plan to fool themselves. Markets can’t rescue a failure to save until it hurts. And don’t let them kid themselves that a smoother ride with bonds won’t come at the cost of increased shortfall risk.
William J. Bernstein is a neurologist, the co-founder of Efficient Frontier Advisors, an investment management firm, and a writer with several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.
Edward F. McQuarrie, Ph.D., is Professor Emeritus at Santa Clara University. He writes about financial history and its implications for retirement planning. Working papers describing his research can be downloaded at https://ssrn.com/author=340720.
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The views presented here do not necessarily represent those of Advisor Perspectives.
