If most Americans already save enough, what should financial educators teach?
The findings of two recent studies underscore the need not only for new forms of retireee-oriented financial education, but also for sound financial education at all ages.
Published July 1, 2007 | July 2007 issue
Most Americans in or nearing retirement have saved enough to meet their retirement needs, according to two recent studies. Is this a sign that further financial education regarding savings and retirement isn't needed? I argue "no." Instead, I think these studies highlight areas of growing importance and unmet needs. They identify some groups who still seem to need basic information on why and how to save for retirement. They also suggest future retirees will be responsible for managing more wealth for a longer period of time than past retirees. These findings underscore the need not only for new forms of retiree-oriented financial education, but also for sound financial education at all ages.
New studies show most older Americans are saving enough
Experts and evidence have repeatedly pointed to shortfalls in retirement savings and related financial awareness. In 2006, for example, the Securities Industry Association reported two-thirds of Americans were not saving enough for retirement.1/ The Employee Benefits Research Institute's annual Retirement Confidence Survey almost always shows that fewer than half of American workers have even tried to figure out how much they need to save for retirement.
In this context, two new studies have gotten a lot of attention by providing detailed evidence that most older Americans have saved optimally and adequately. Saving optimally means saving as well as you can, given your resources and circumstances. Saving adequately is different; it means saving enough to avoid poverty.
The first of the two studies, conducted by researchers John Karl Scholz, Ananth Seshadri and Surachai Khitatrakun (SSK), judges the optimality of older Americans' savings.2/ It uses data from the 1992 Health and Retirement Survey3/ (HRS) of households headed by individuals who were born between 1931 and 1942. SSK calculated how much a household would need to save in order to keep its annual consumption in retirement about on a par with the level it was accustomed to before retirement. This standard is widely used in economics and financial planning; it assumes that most of us dislike big changes in our overall level of consumption over time. SSK used data on households' annual earnings and their likely future Social Security and employer-funded pension benefits (if any) to determine each household's target level for marketable net worth—in other words, the amount each household would need to accumulate, in addition to Social Security and pension payments, to keep consumption nearly constant throughout life.
Figure 1 (below) illustrates three of SSK's important findings. First, the target levels of net worth vary considerably by income and are quite low for the lowest-earning households. This reflects the fact that the optimal rate of savings for households with limited income is very low, in part because Social Security alone will nearly maintain their normal standard of living. Such households may be better off saving very little for retirement, perhaps just a modest rainy-day fund, given their limited pre-retirement resources. Second, at all income levels, including the very lowest, most households meet or exceed their individual net worth target. Overall, 84 percent of all households have accumulated their targeted net worth or more. Third, many households have saved more than they need to maintain essentially unchanged consumption levels in retirement.
SSK found that households who fall short of their savings target usually miss it by a fairly small amount. In the middle of the lifetime earnings distribution, only 10 to 22 percent of households fell short of their marketable net worth targets, and their typical shortfall was between $5,000 and $15,000. Among very low-earning households, about 30 percent failed to hit their savings target, but the shortfall was under $5,000. SSK also found that the higher percentage of low-income households who fall short of their savings target is related to the tendency of low-income households to be headed by a single person; absence of a spouse correlates more consistently with suboptimal savings than does lack of income.
In the second of the new studies, researchers David Love, Paul Smith and Lucy McNair (LSM) examined whether retirees have enough wealth to live above the poverty threshold throughout retirement.4/ They found that most older Americans meet or surpass this target. Using data from the 2004 HRS, LSM studied households where the survey respondent or spouse was born between 1931 and 1953. They tallied each household's comprehensive wealth, including marketable net worth plus expected future retirement income such as Social Security, employer-funded pension payments, or public assistance (if any). They then converted comprehensive wealth into an annuity amount, representing what the household could afford to spend annually in retirement if it made full use of all wealth. The results, summarized in Figure 2 (below), show that the median household could spend about $31,500 annually per person.5/ Consistent with SSK, LSM found that households headed by single people have less wealth per person; the median single household can afford to spend only $26,000 per year, versus $35,900 per person for the median married household.
As Figure 2 also shows, LSM found a wide dispersion in wealth, income, and associated retirement purchasing power. Households in the lowest 10 percent of the overall wealth distribution can only afford annual spending of $9,100 per person in retirement. Among households in the lowest third of the distribution of lifetime earnings, the median household can expect to spend $15,600 per person annually in retirement. However, within the same lowest third, those who fall in the lowest 10 percent by wealth (i.e., about 3 percent of the population, or 10 percent of one-third) can afford to spend just $3,400 per person per year.
LSM also compared households' annual future spending power to projected future poverty thresholds. They found that the median household can expect a standard of living in retirement that is equivalent to more than three times the poverty threshold. About 80 percent of all households can afford per capita retirement spending of 150 percent or more of the poverty level. Even for those in the lowest third of lifetime earnings, the median household exceeds the 150 percent level. As in the SSK study, low savings are found mainly among single and low-earning households.
Together, the SSK and LSM studies imply that most older Americans have saved well and can live out their days in reasonable or better material comfort. However, their results depend on certain assumptions. For example, there's the assumption that households will spend all of their home equity in retirement. Many households say they won't, which would cut their retirement spending power. Some researchers raise questions about whether these studies make sufficient allowance for out-of-pocket medical expenses in later life or for other savings objectives, such as rainy-day funds and down payment accumulation, before retirement.6/ The SSK and LSM studies cover a generation that experienced rapid appreciation of stock prices and home values during their working lives. Similar estimates of how well younger generations are saving are not yet available. We can thus expect more research on this topic. Nonetheless, the two studies are considered among the best ever on these matters, as judged by the quality of the data and models used, and their implications for financial education and public policy should be taken seriously.
Implications for financial educators
The SSK and LSM studies can help financial educators design and target their services. For example, educators need to learn more about why savings differ between single and married households. In the meantime, they may need to better target savings education to single households. For households with very low lifetime incomes, education on retirement savings may be less important than information on basic coping strategies, such as how to establish a modest rainy-day savings fund or apply for the Earned Income Tax Credit and other assistance programs. Basic information on how to stay healthy would also be useful, since good health reduces medical expenses and enables people to continue working.
Managing risks to older Americans
The two studies suggest that for most older Americans—those who have substantial net worth—well-being in retirement will depend on how well they manage their wealth and expenses in the face of significant risks. Financial education on these topics could be very useful.
For example, a large part of household wealth is marketable net worth, consisting of assets owned and managed by the households. Examples include home or business equity, bank accounts, stocks and bonds, mutual funds, 401(k)s or other retirement accounts. Many households will need to decide how fast to spend down their principal and whether to convert some assets into annuities. These are complicated decisions, with additional considerations when the use of home equity loans or reverse mortgages is involved.
Many households will hire financial advisors to help make these decisions, but this is only part of the solution. Even those who can afford professional advice have to ask good questions and verify that the advice is truly in their interest. As we have learned in the mortgage market, the household's understanding of basic financial principles is a first line of defense against fraud and abuse. I see an ongoing need for education to help older households manage their growing pool of financial assets.
Older households will also benefit from information that helps them manage the risks of having significant expenses in retirement. One such risk is longevity, or the risk of living longer than expected. One way for individuals to manage longevity risk is to self-insure, either by saving a lot or spending conservatively, so they can afford to live a long time. However, many households might be better off pooling some of their longevity risk with other households. In this type of mutual insurance, an individual pays a lump sum based on his or her expected lifetime and gets back a certain fraction of that amount in the form of an annuity. Those who die earlier than expected end up getting back less (in present value) than they put in, and the difference is used to fund the payments to those who live longer than expected. In principle, everyone benefits by mitigating longevity risk, which is the basic logic of annuities. But Americans traditionally have not embraced annuities. We need to learn more about why that is, and I think we need to give older Americans more information about longevity risk and how it can be managed.
Healthcare is another significant expense risk for retirees. Medical expenses, including out-of-pocket expenses paid by the elderly, have risen significantly since 1993 and are expected to continue rising.7/ Barring a fundamental change in healthcare financing, escalating expenses suggest an increasing need to educate the elderly about healthcare spending accounts, Medigap insurance, long-term care coverage and other means of managing medical-expense risk. Financial educators may want to partner with health and wellness educators, since postponing debility through lifestyle decisions is also an effective financial strategy.
Although they focus on older Americans, the studies I've highlighted also have implications for what financial educators should be teaching Americans under age 50. For example, increasingly sophisticated financial planning software packages might help these households choose their savings levels and make their investment decisions more confidently, provided financial educators help them understand how to find and use a reputable program that addresses their needs.
Providing financial education in the workplace may be especially effective for this age group, because the workplace is where most Americans hold their wealth. Forty-five percent of all workers, and 82 percent of eligible workers, have an employer-sponsored savings plan, compared to just 36 percent who have an individual IRA. Seventy percent of workers have half or more of their retirement savings in an employer-sponsored plan.8/ These plans are often the most convenient way for workers to invest in stocks, bonds, and other nonbank financial assets. The workplace is thus the one location that combines a worker's assets, investment options and decision points. That makes it a potent location for effective financial education as well.
A recently enacted federal law should enhance the financial planning importance of the workplace. The Pension Protection Act of 2006 encourages employers to automatically enroll employees in defined contribution plans—a practice that has been shown to significantly boost participation, especially in the early years of employment.9/ The act also makes it easier for employers to provide financial education, including objective professional advice about how to invest for retirement.
Instilling a foundation
Recent findings that most older Americans are saving optimally and adequately for retirement are good news, but they do not imply that Americans have all the financial education they need. In fact, the two studies discussed here suggest that some groups still lack basic knowledge about savings decisions, while others may need better information about how to manage and spend retirement wealth. Financial educators can use this research to better target their outreach to retirees and workers. Public policymakers can help too, such as by consolidating and simplifying tax incentives for savings, resolving the uncertainty about future Social Security and medical program benefits and tax levels, and providing the infrastructure and oversight to allow markets for retiree risk management tools like annuities, reverse mortgages, and long-term care insurance to function predictably and fairly.
I think the two studies also highlight the importance of instilling a strong foundation of general financial understanding in Americans at an early age. Instead of focusing on the basic mechanics of financial management, like balancing a checkbook, we should help young people understand key financial concepts, such as the need to make budget-conscious choices, the power of compounding, the trade-off between risk and return, the importance of diversification and the workings of insurance markets. The success of financial education will be limited unless we maintain a sound general education system in which students master the basics of reading, mathematics and rational decision making. Programs that promote these essentials, ranging from good nurturance in early childhood to excellent K-12 schools, provide the foundation for financial education and future financial security.
1/ Retirement Savings: By the Numbers, Securities Industry Association, June 2006.
2/ "Are Americans Saving 'Optimally' for Retirement?" Journal of Political Economy, Vol. 114, No. 4, The University of Chicago, 2006.
3/ The HRS is conducted biennially by the University of Michigan, with support from the National Institute on Aging.
4/ Do Households Have Enough Wealth for Retirement? Federal Reserve Board, March 2007.
5/ Dollar projections in the LSM study represent 2004 purchasing power.
6/ Jonathan Skinner, Are You Sure You're Saving Enough for Retirement? National Bureau of Economic Research Working Paper 12981, March 2007.
8/ Ruth Helman, Craig Copeland and Jack VanDerhei, Will More of Us Be Working Forever? The 2006 Retirement Confidence Survey, Employee Benefit Research Institute Issue Brief No. 292, April 2006, p. 22.
9/ Ericca Maas, "Aim of Pension Protection Act is to increase personal retirement savings," Community Dividend Issue 2, 2007, Federal Reserve Bank of Minneapolis.