Sent: 27-10-2009 11:55:02
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Is Retirement Saving In The US Really Any Different?
As readers of the publication will know, I have relocated to the US to continue my work, hopefully utilising my knowledge and expertise in retirement savings in a new environment. However, some will point out that unlike Australia where saving for retirement is compulsory, in the US it is voluntary which of course begs the question, will my experience translate? I would argue yes and would even go so far as to suggest that Australians financial planners have experience that many US planners lack and will desperately need in the near future.
Along with health care, retirement security is one of the most critical financial issues facing governments, employers, and individuals around the world. It has the potential to strain national economies for several decades unless action is taken. In many instances, the over-65 population will not only be larger than any time in history, it will also have a longer life expectancy than any of its predecessors with many of the cohort facing 'retirement' of 30 years or more.
With over US$12 trillion in assets, traditional pension trusts and 401(k)-style saving plans account for the vast majority of financial assets accumulated by households in the US. With the move towards consumer driven retirement planning, DC plans have become more popular as they provide increased flexibility and control. However, with this flexibility and control comes significant responsibility.
Unfortunately, approximately 50% of the US workforce has no work site retirement savings plan and among those with access to a DC plan, more than one in five chose not to participate. Employees who do participate tend not to save enough and not to increase their rate of saving over time. Less than 10% of 401(k) participants make the maximum allowable annual contribution to their plans. Less than 17% increased their contribution rates in 2005, while almost 10% decreased their savings rate. Of those who did contribute, almost a quarter failed to contribute enough to obtain the full company match despite financial incentives to do so.
Consequently, whilst individuals are being required to assume greater responsibility for managing their own retirement plans, the evidence suggests many are often not making the right decisions to ensure a secure retirement. As a result up to half of all households will not be able to maintain their standard of living in retirement even if they retire at age 65, three years later than today's average. Consequently it is now accepted that in the US, coverage, participation and contribution rates are all areas that need to be addressed.
It should therefore not be surprising that the 2008 Retirement Confidence Survey (RCS) found that confidence in being able to afford a comfortable retirement has dropped to its lowest level in seven years, across all age groups and all income levels. Yet this decreased confidence appears to have had little affect on the way most Americans plan and save for retirement. The RCS revealed that faulty assumptions still hinder a realistic assessment of the preparations needed to ensure a financially secure retirement. Consequently, almost 70% fear their retirement future will be financially difficult even before consideration is given to the prospect of supporting aging parents, children, or even grandchildren. Across the board, employees view themselves as failing in confidence and execution of their retirement savings, which is why the reforms contained within the 2006 Pension Protection Act have been welcomed.
The 2006 Pension Protection Act (PPA)
What, I hear people asking, is the PPA? This piece of legislation was described in a recent CFA article as the most sweeping pension reform enacted in the US in more than 30 years. This is because it aims to change employee behavior by encouraging employers to offer plans that automate a number of decisions. This is based on the theory that automatic enrollment will reverse the decision inertia of employees, given that many simply take the line of least resistance and do not make an active decision when asked to join a retirement savings plan. Therefore automatic enrollment aims to leverage such decision inertia requiring people to actively 'opt out' of retirement savings plan, thereby increasing participation levels.
However, the use of such an approach increases the significance of the default options as these will become the automatic choice where decision inertia occurs. As the most common default contribution rate among DC plans is 3%, the PPA allows for a gradual increase over time. Automatic enrollment also increases the importance of the default fund as even those strongly motivated to participate, many lack the expertise to decide which investment choices best meet their needs. Given that the portfolios of approximately half of 401(k) participants lack proper diversification, the PPA enables DC plans to automatically default to a diversified portfolio. As a result target date funds have been developed using asset allocation mixes that reflect the saver's situation with the flexibility to adjust appropriately as the saver draws closer to retirement age.
Consequently, the PPA marks a significant change in the philosophy behind 401(k) style retirement savings plans. However, based upon both my practical experience and knowledge gained whilst researching both voluntary and mandatory retirement savings across a number of countries, I would argue that the PPA is a good start but will not on its own solve the underlying issues. In fact, I fear that the options designed to make saving for retirement easier, have the potential to make the problem worse over time.
I will explain why next time and demonstrate why Australian planners may be able to offer advice to their US counterparts.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.