Would you buy a car if it worked only 50% of the time?

For members of defined contribution (DC) plans, 50% of the time retirement objectives will not be met if retirement plan calculations are based on average investment return and average life expectancy. This means that around half the time, investment expectations will not be fulfilled.

Roughly half the population will outlive their life expectancy. This is illustrated in the graph below:

* For the illustration, life expectancy for 65-year-olds is based on Mercer research on Australian public sector pensioners, allowing for ongoing improvements.

This is an issue for both the pre- and postretirement phases.

Pre-retirement phase

Basing retirement planning on average life expectancy and investment returns means that employees with DC plans may not be aiming for the right target level of benefits to be accumulated at retirement.

Consider the graph below. Based on average life expectancy and investment returns, a lump sum of $500,000 at age 65 might be sufficient to provide the desired retirement income. 

(Results produced using Mercer’s DC spend-down model)

However, when the plan is analyzed using varying rates of life expectancy and investment returns, it is clear that a lump sum of $500,000 will be sufficient only 50% of the time.

To achieve a greater degree of certainty in meeting retirement objectives, $700,000 (only 20% chance of failure) or $800,000 (10% chance of failure) is required at retirement.

Postretirement phase

Similarly, in retirement, use of average longevity and investment assumptions can lead to an overly optimistic retirement plan.

Using average longevity and investment assumptions for $500,000 invested in an account- based pension (or a mutual fund-type product), drawing down $50,000 per year seems reasonable.

However, this is a plan with a 50% chance of failure. A more sophisticated analysis yields a different picture.

The graph above shows that the chance of failure is highly sensitive to the pace of money drawdown in retirement. Reducing annual drawdowns by only $5,000 can have a dramatic effect on the chances of success.

Longevity risk and investment risk are related in the postretirement phase

Of course, the more you draw down, the more likely you are to run out of money. But the mix of longevity risk and investment risk depends on the pace of the drawdown.

If you never drew down the money, the money would never run out and therefore there would be no longevity risk, only investment risk. If you draw down all the money in the first year, then there would be no investment risk, but high longevity risk.

Product innovation in Australia

Australia’s compulsory “Superannuation Guarantee” system commenced in 1992 with compulsory employer contributions of 3% of salary. This level increased over the years to reach 9% of salary in 2002, where it remains today.

The gradual maturing of the Superannuation Guarantee system has led to increased levels of benefits – now and projected in the near future – and to a number of recent product innovations.

One might think that lifetime annuities and variable annuities offer solutions to longevity and investment risk. But these products come at a substantial cost. Moreover, the different terms and conditions make a comparison very difficult. Some of the items that need to be compared are:

It is simply not possible for an individual to determine the best product by comparing each feature of the alternatives and aligning them with his/her objectives and risk profiles. A sophisticated, stochastic model, such as Mercer’s spend-down model, is required.

Consider the nuances when planning

The analysis above demonstrates that a more nuanced approach to DC planning (particularly in the retirement phase) is required to better consider longevity and investment risks. Mercer’s DC spend-down modeling tool can be used to assist employers and fiduciaries that are assessing DC plan design – especially in the retirement phase. The model is also useful in assisting fiduciaries in:

Modeling helps – it is better to have a process that yields success for a majority.