Tim Noonan, Managing Director, Capital Markets Insights
Here’s the good news: According to the latest projections from the Society of Actuaries, we’re all apt to live longer. 1 And the bad news: That means we’ll need more money to get us through retirement.
In his recent report on the $20 Billion Club, my colleague Bob Collie describes the challenging blow the latest RP-2014 actuarial tables have delivered to 19 large pension plans that represent roughly 40% of the pension assets and liabilities of U.S. publicly listed corporations. 2
In the past year, these corporations factored the new life expectancy figures into their pension liabilities, with predictably significant results. Between the updated longevity figures and continued low interest rates, they now are carrying a collective pension deficit of $183 billion – up sharply from $114 billion at the start of the 2014 financial year. 3
And if they’re feeling this burden, so will most everyone else who considers retirement part of their future. The $20 Billion Club serves as a reasonable proxy for many U.S. corporations with defined benefit pension plans. By extension, their experience should motivate individual investors and their financial planners to take an honest look at retirement sustainability.
According to Collie’s report, it will be no small feat for the 19 big pension holders to close the funding gap – the same holds for many other corporations in a similar bind. While some of them can direct more money into pensions, this can have an unwanted, jarring impact on corporate balance sheets and shareholders.
Typically, these retirement plans have two other options. One is to load up on risk and bet that equities will close the funding gap. But when the numbers are this large, if something goes wrong, the impact can be huge – hitting not only the pension’s funded status, but corporate balance sheets as a whole.
Alternatively, pension plans can factor in the increasing likelihood that the Fed, will gently increase interest rates beginning mid-2015. Such an increase would be positive news for pension plans. However, the fixed-asset markets may already have factored the long-pending hike into pricing, making the impact of higher interest rates less helpful.
Pension liability tune-ups
So what’s a corporation to do? Based on Collie’s findings, an increasingly popular option is “liability responsive asset allocation,” which essentially tries to combine the best features of several options. Let’s say a pension fund is covered for 70% of its liabilities. Its manager may opt to take on additional risk, with the hope that doing so will increase that plan’s funded coverage. If things go well and rising assets increase a plan’s funded coverage to, say, 80%, then the fund manager may allocate more into bonds or other fixed-income assets, reducing risk. As pension coverage improves, more risk is shifted out until – if all goes well – the plan is funded to healthier levels and assets can be shifted to a lower-risk portfolio.
It's getting personal
For individuals and their financial advisors, the new actuarial tables should force a closer look at their own situation. Unfortunately, for too many people, a financially secure retirement is a long shot, as outlined by research from the National Institute on Retirement Security. 4 For those who have set aside savings and investments, the vital question is: Will it be enough? In light of expected greater longevity, it’s no trivial issue.
For many retirees, planning has been kept pretty simple: A financial advisor may look at their account and their expected expenses, and simply come up with a dollar figure or a percentage of principal assets to define the amount a retiree can affordably pull from his or her account each year. But that doesn’t accurately reflect what a person may actually need – or even whether they’re entering retirement with enough money.For many retirees, planning has been kept pretty simple: A financial advisor may look at their account and their expected expenses, and simply come up with a dollar figure or a percentage of principal assets to define the amount a retiree can affordably pull from his or her account each year. But that doesn’t accurately reflect what a person may actually need – or even whether they’re entering retirement with enough money.
The math that counts
There’s a better approach: A “funded ratio” can help predict required retirement assets and actual needs. The math isn’t complicated – a simple equation looks like this: a/b , with “a” representing all current savings as well as anticipated future earnings or income, and “b” representing all expected expenses. If “a” is equal to or larger than “b,” then a retirement account is likely funded to cover retirement – even an unexpectedly long one. If “a” is smaller than “b,” well, time to make some important decisions.
A lot of good can come from performing this exercise. It forces people to examine the future state of their finances. It either helps reassure people that they’ll be fine, or awakens those who won’t be – perhaps prompting a change in behavior.
Moment of reckoning
The math also creates a moment of clarity that can help put options into true focus. Let’s say someone is funded to about 90% and is entering retirement. There’s not much they can do to change that funding ratio. An investment advisor who keeps them heavily allocated in stocks in the hope of making up the gap may be acting irresponsibly. In reality, that new retiree has little risk capital – they may need to take what they have and purchase an annuity, which will pay them a pre-determined amount at specific intervals based on the terms of the annuity’s contract.
On the other hand, a prospective retiree who is funded at 135% of their retirement needs or better has comparatively less to worry about. Unfortunately, anyone who enters retirement with a funded ratio much below about 80% may not have enough time or resources to avoid the risk of running out of money during a long retirement life. But between those two poles (80%-135%), and especially in the terrain just below and above 100% funding, there’s rich ground for discussion.
Here’s why: If an investor is a little over-funded, he or she may protect themselves from becoming under- funded by reducing exposure to risk or purchasing some annuities. If the investor is somewhat under- funded, then some not-too-painful changes in spending and saving may make up the gap, leading to a much happier retirement.
For too many people, it’s easy to take a fearful view of retirement – especially its end, which is often envisioned as spent in a nursing home battling costly health issues. Maybe it’s time to be more optimistic than that. It’s very possible that many new cures and treatments are a decade or so away. That would greatly change the dynamic of retirement, perhaps creating a more positive view of retirement as a more sustaining period of life.
Certainly, current actuarial numbers show that retirement will last longer than ever. For big plans and financial advisors alike, it’s time to take that fact into account.
1 “RP-2014 Mortality Tables Report,” Society of Actuaries, November 2014
2 The Pension World’s $20 billion club stung by improving longevity,” Russell Investments, February 2015
3 “The Pension World’s $20 billion club stung by improving longevity,” Russell Investments, February 2015
4 “The Continuing Retirement Savings Crisis,” National Institute on Retirement Security, March 2015
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First used: April 2015