How Important is Asset Allocation to Financial Security in Retirement?

Transcription

1 How Important is Asset Allocation to Financial Security in Retirement? Alicia H. Munnell and Anthony Webb Center for Retirement Research at Boston College Pension Research Council Symposium Philadelphia, PA May 3-4, 2012

2 1 Retirement needs are increasing people are living longer and Cohort Life Expectancy at 65, Men and Women, Years Men Women Source: U.S. Social Security Administration Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office.

3 2 they continue to retire early. Workforce Participation Rates of Men Ages 50-74, 1970, 1990, and % 75% % % 0% Age Source: U.S. Bureau of Labor Statistics. Current Population Survey, 1970, 1990, and Washington, DC.

4 3 But the retirement system is contracting. Retirement Income Social Security Employer-Sponsored Pensions Individual Saving Defined Benefit Plans Defined Contribution - 401(k) - Plans

5 4 To bridge the gap between needs and resources, households have four levers. Adopt optimal asset allocation Work longer Take out reverse mortgage Control spending

6 5 Financial advice focuses on asset allocation, despite most households modest wealth. Wealth Holdings of a Typical Household Ages 55-64, 2007 $300,000 $298,900 $200,000 $138,600 $122,100 $100,000 $0 $50,500 $29,600 $36,900 Social Security Primary house Defined benefit Defined contribution Financial assets Other assets Sources: Authors calculations based on U.S. Board of Governors of the Federal Reserve System. Survey of Consumer Finances, Washington, DC.

7 6 Three exercises suggest that other levers may be more effective: A simple stylized example of households required saving rates. An HRS analysis showing how each lever affects the percent of households unprepared for retirement. A dynamic programming model that calculates the riskadjusted value of moving to an optimal portfolio.

8 7 The first analysis calculates the required savings rate for a hypothetical individual. Replacement Rate Needed to Maintain Pre-Retirement Income 100% 80% Required income from savings Social Security 60% 39% 40% 20% 41% 0% Source: U.S. Social Security Administration Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. Washington, DC: U.S. Government Printing Office; and B. A. Palmer GSU/Aon RETIRE Project Report. Research Report Series Atlanta, GA: J. Mack Robinson College of Business, Georgia State University.

9 8 The most important factors are the age the worker starts saving and the retirement age. Saving Rate Required for a Medium Earner to Attain an 80-Percent Replacement Rate with a 4-Percent Rate of Return Retire at: Start saving at: % 35% 65% Source: Authors calculations.

10 9 And working a few years longer can offset a lifetime of low returns. Saving Rate Required for a Medium Earner to Attain an 80-Percent Replacement Rate with a 2-, 4-, and 6-Percent Rate of Return Retire at: Real rate of return 2 percent 4 percent 6 percent 62 46% 35% 26% Source: Authors calculations.

11 10 The second analysis uses the HRS to calculate the impact of each lever. Nationally representative sample of households from HRS Projected Replacement Rates at Ages = Percentage of Households Falling Short Life-cycle savings model (Georgia State) Target Replacement Rates

12 11 Projected replacement rates are based on the following assumptions/data: Item Social Security Defined benefit pension wealth Key assumption/data sources HRS Social Security earnings records. Self-reported data. Returns on financial assets Equities = 6.5%, bonds = 3%, short-term deposits = 1%. House Income in retirement At retirement, mortgage repaid from financial assets to extent possible. Financial assets used to purchase inflation-indexed annuity.

13 12 The levers are defined as follows: Item Asset allocation Working longer Reverse mortgage Control spending Key assumption Invest 100 percent of financial assets in riskless equities. Higher Social Security benefits, 401(k) balances, and annuity rates. Take out maximum loan and exercise lifetime income option. Save additional 5 percent of income and reduce target by 5 percentage points.

14 13 Baseline results at different ages show the power of working longer. Percentage of Households Falling Short, Ages % 90% 89% 80% 74% 70% 65% 60% 59% 53% 47% 40% 40% 34% 28% 20% 0% Age of retirement Source: Authors calculations.

15 14 Comparing the power of each lever shows that asset allocation is less effective. Percent of Households Falling Short of Target at Ages 62 and 67, Full Sample 80% 60% 40% 74% 73% 71% 67% Base case All riskless equities Control spending Reverse mortgage 47% 44% 41% 36% 20% 0% Age Source: Authors calculations.

16 15 Households in the top decile are less at risk, but otherwise the story is similar. Percent of Households Falling Short of Target, Top Wealth Decile 40% 30% 39% 37% 36% 37% Base case All riskless equities Control spending Reverse mortgage 20% 17% 14% 14% 15% 10% 0% Age Source: Authors calculations.

17 16 The final analysis takes account of risk, using dynamic programming. Calculates optimal consumption given: o o optimal asset allocation; and typical asset allocation. Calculates the dollar amount the household requires to move from optimal to typical.

18 17 Optimal equity allocation varies with wealth and risk aversion. Typical and Optimal Portfolio Allocations, Percentage in Equities 120% 80% 100% 51% Typical stock allocation Optimal allocation - CRRA = 2 Optimal allocation - CRRA = 5 57% 70% 40% 36% 29% 0% Typical household Top-decile household Note: Optimal stock allocations are shown at age 65. Source: Authors calculations.

19 18 The results show only modest payments are required. Amount Required as Compensation for Retaining Typical Portfolio Allocation, 2008 Dollars $100,000 $80,000 CRRA = 2 CRRA = 5 $87,000 $60,000 $40,000 $20,000 $0 $25,700 $5,600 Typical household $20,000 Top-decile household Source: Authors calculations.

20 19 Conclusion Many households are not on track to maintain their living standard in retirement. Financial advice tends to focus on asset allocation. But most households don t have many assets. So asset allocation is generally less powerful than working longer, taking a reverse mortgage, and controlling spending.