As the US continues to struggle with its retirement savings woes, a wide range of solutions have been proposed to try and address the problem, with varying degrees of success and adoption. From defined benefit and defined contribution plans, from nudges to mandatory contributions, there is little consensus on the best way forward.
In a new paper, behavioral finance researcher Meir Statman makes the case that the primary reason many proposals have fallen flat is that they do not properly segment prospective retirees, as the needs and issues – and potential solutions – are substantively different depending on whether the target is the wealthy, the poor, or the middle. And even amongst the middle, the needs of the steady earners and savers is far different than those who may have the income by are struggling to save due to spending.
Once viewed from this perspective, Statman finds that many of our current solutions become more clearly ineffective – for instance, annuities don’t help the wealthy and upper-middle who don’t need them, and don’t help the poor and much of the lower-middle who can’t afford them. In turn, Statman suggests that perhaps a better solution is to actually implement a form of mandatory retirement savings – already implemented or being rolled out in many countries around the world – as those who are having trouble making the choice to save may find it “easier” when it is no longer a choice at all, while the wealthy and steady-middle that financial planners already save may be little impacted as they were already likely to save already!
The inspiration for today’s blog post is a recent article by Meir Statman in the latest edition of the Journal of Retirement. In his article “Retirement Income for the Wealth, The Middle, and the Poor” Statman makes a compelling case that our discussions of retirement income have been confused by the fact that different portions of the population have substantively different needs and concerns, and that only be properly segmentation can real retirement issues be addressed.
Segmenting Prospective Retirees
The primary segments that Statman suggests in his article are the Wealthy, the Middle, and the Poor. The Wealthy are those who are able to earn ample income during their working years to save more than enough to fund a comfortable retirement; their retirement concerns (in Statman’s view) will revolve primarily around issues like estate taxes, and status competitions with their wealthy neighbors. The Poor, by contrast, are those who are unable to earn adequate income to save enough (or at all) to fund their retirement.
In the case of the Middle, Statman breaks the category into several sub-groups. At the top are the “steady-middle” who earn adequate incomes to steadily save throughout their working years for their retirement – perhaps not as lavishly as the wealthy, but enough to achieve a comfortable retirement. At the lower end of the Middle are the “precarious middle” who might be close to funding their retirement but are struggling to save enough.
In turn, the precarious middle is broken into two further sub-categories: the “low-earners” who simply struggle to save enough for retirement due to marginal earning power, and the “high-spenders” who might have enough income to theoretically be able to save but spend so much that they don’t have enough for retirement after all.
The graphic below illustrates these retirement income groupings:
Different Needs And Issues For Different Segments
Given these different retirement groupings, Statman makes a compelling case many/most of the solutions around retirement planning and retirement income tend to focus on one group or another in particular, without any acknowledgement of the reality that those solutions may be less effective or totally ineffective for others.
For instance, while annuities are often promoted as a good solution to solve the issue of longevity risk, Statman notes that in practice the Wealthy don’t need them (as they have ample funds to handle longevity risk anyway), and the precarious middle and poor can’t afford them; at best, they’re really only a prospective solution for the steady middle, yet even that group is often so steady and conservative in its spending – allowing them to be in the steady-middle group in the first place – that it’s not clear an annuity solution necessarily helps them, either.
Similarly, other typical retirement planning issues vary greatly amongst the groups. For the precarious middle and the poor, managing $15,000/year of health insurance and medical costs can be problematic or outright destructive to their retirement, yet is often quite manageable for the steady-middle and a non-issue for the wealthy. And overall, the composition of spending itself varies greatly by group, which also impacts their resiliency to adverse economic events; the wealthy and steady-middle tend to have a larger portion of spending that is discretionary and therefore flexible, while the precarious-middle and poor may have little room to adapt to the smallest bumps in the retirement road.
Segmenting Retirement Solutions
In light of these retirement dynamics, Statman suggests that our current policies for supporting retirement may be less effective than we believe. In recent years, retirement policy has tended towards what behavioral finance researchers Thaler and Sunstein have described as “libertarian paternalism” – a midpoint between a purely paternalistic approach (e.g., mandatory retirement savings) and an entirely libertarian one (total freedom to choose to save or not), where the libertarian-paternalistic policies “nudge” people in a particular direction without restricting their freedom (e.g., automatic enrollment to retirement plans with the choice to opt out but the default to participate).
Statman suggests that such approaches have been a benefit primarily for the stable-middle, but that they are far less effective for the precarious-middle and the poor. In the case of the latter, they simply don’t have the cash flow available to save; for the former, low-earners struggle to save as well, and the high-spenders aren’t being influenced enough by the nudge to change their behavior. Accordingly, Statman actually suggests that a more paternalistic approach – similar to what has been implemented or is planned in several countries around the world, including Australia, the U.K., and Israel – may be a better solution.
Statman’s version of the paternalistic approach would combine mandatory contributions by employers and employees for a minimum of 12% of earnings, in a 401(k)-like structure but with a central government-agency-supported option for those who don’t have the option via work, with default offerings into a well-diversified low-cost target-date fund. In theory, such an approach would have little impact on the wealthy (they can afford it), and the steady-middle (they would have saved anyway), but may help the precarious-middle (especially the high-spenders group), and could be partially subsidized by the $93 billion/year we’re already allocating to tax expenditures for voluntary defined contribution plans (notwithstanding fears of reducing or eliminating retirement account tax deductions, a recent study of the results when such a change was implemented in Denmark 14 years ago found that in reality only 15% of savers reduced their contributions and 98% of the reduced amounts were simply redirected to another investment account). In essence, the mandatory savings program would form the middle of a 3-layer approach to retirement savings that includes Social Security as a base and voluntary savings on the top.
While I imagine that many (most?) planners would push back on a mandatory savings approach in lieu today’s voluntary program that allows for more planning flexibility, Statman does have an interesting point that the impact of a mandatory contribution program might be less disruptive than many believe, especially if the impact is partially mitigated by adjusting how some of today’s tax expenditures on retirement are currently allocated.
From a broader perspective, though, Statman does have a compelling point that when discussing retirement planning, strategies, and research, it may be constructive for us to start to clarify which group we’re talking about – though notably, I suspect that most planners consistently work almost exclusively with the Wealthy and the Steady-Middle groups. Nonetheless, as we look overall at what can be done to address the country’s retirement savings challenges, it is perhaps time to take a more nuanced approach and recognize that the tools and strategies that work best for some groups may be doing little to nothing for the others.
So what do you think? Do you find the wealthy/middle/poor a helpful way to think about and frame retirement issues? Would you ever support a moderate mandatory savings program as a “middle layer” of retirement above Social Security and below purely voluntary savings?