Retirement Readiness During Times of Instability
Insights from Aon's The Real Deal Research
Retirement readiness may be far from the minds of many people as the world copes with the challenges associated with COVID-19. The good news is the work that plan sponsors have put into both making their plans run as efficiently and effectively as possible and providing financial education to employees can pay off in this time of instability. Best practices, such as appropriate risk allocation, automatic rebalancing, and automatic savings features, can help keep retirement plans on track without additional input from employees. But even with these practices in place, retirement accounts - and therefore, retirement readiness - may be diminished. By understanding the impact of today's reality, employers can be better prepared to help their employees now and in the future.
Plan participants will bear the brunt of market losses primarily in their defined contribution plans. Employees who have a defined benefit plan, whether frozen or ongoing, will have more retirement income security at this time.
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Disruptions in Savings are a Primary Threat to Retirement Readiness
During challenging economic times, individuals may experience reduced or lost wages within their families. In this situation, some people choose or are forced to stop contributing to their defined contribution plan or even tap into their plan balances to cover immediate expenses. The CARES Act1 expanded the ability for participants affected by COVID-19 to take distributions from retirement plans without certain negative tax implications.
While their ultimate retirement readiness may not be an immediate concern to someone in this situation, it is helpful for employers to understand the impact of disruptions in savings or distributions from retirement accounts. When the employee is back in a more stable financial position, the employer can help the employee to get back on track for the future.
As an example, take a 45-year-old who saves 7% of their $50,000 salary and receive a dollar-for-dollar employer match on up to 6% of pay. If the participant stops saving for one year, the impact is expected to be fairly small - about a $20,000 reduction in their expected resources at retirement (including lost match) - but only if they resume saving at their prior level of 7% the following year. A more realistic savings pattern may be to gradually ramp up by 1% a year to the prior savings level. In this scenario, the reduction in projected retirement assets at age 67 could be as much as $80,000, equating to a 5% reduction in the standard of living they might otherwise have had in retirement.
A large distribution from a participant's defined contribution account can also have a significant impact. For the 45-year-old example, withdrawing $25,000 today could reduce the balance at retirement by about $70,000, on top of any reduction due to suspended savings. A combined projected account balance reduction of $150,000 could require the participant to defer retirement by two years in order to be in the same position as before.
Keep in mind, these examples exclude any impact of market losses, which the next section addresses.
Market Losses Affect Individuals' Retirement Readiness Differently
Most people will have seen significant changes in their defined contribution accounts during the first half of 2020 due to COVID-19 pandemic and resulting market downturn. However, the consequences for retirement finances vary widely based on several factors, including:
- The asset classes each participant is invested in;
- Future market returns;
- The proportion of the participant's balance already in the plan compared to expected future contributions; and
- The number of expected years until retirement.
Even though early-career participants may be more heavily invested in riskier assets, they will have more time to recoup losses and may have smaller accounts subject to the market losses, compared to their peers who are approaching retirement and have generally larger balances.
Exposure to Market Downturns Varies by Age
Target date funds are designed to automatically shift the asset allocation toward less risky assets over a person's lifetime. Many participants invest their defined contribution balances in target date funds or follow the general principle of derisking as they get older, so those closer to retirement may not have seen as much change in their retirement account balances as those who are earlier in their careers.
Participants' market losses vary by asset allocation, which is typically correlated with age.
An Unpredictable Future
The future investment returns on a defined contribution balance are unknown and largely out of the participant's control. If there is a full market recovery before a participant retires, there would be no impact to retirement readiness. However, it is unclear if or when a full recovery will happen, so we have considered two potential scenarios:
The magnitude of the strategies needed to adjust for the market downturn varies by age.
How Might Participants Respond to Changes in Their Retirement Readiness?
Ultimately, this market downturn may impair retirement readiness, depending on how future returns play out. Employees may have to save more, retire later, or prepare themselves for a lower standard of living in retirement.
In the Moderate Recovery scenario, we model negative returns for 2020, which are typically more severe for the younger participants. However, because they may have smaller current balances and the opportunity to make up losses over several decades in the future, the typical 25-year-old's retirement readiness picture in largely unchanged.
For a sample 60-year-old participant, this decline in assets may increase their retirement income shortfall by 1.3 times final pay. The participant has three primary strategies to adjust for this additional shortfall:
- Save an additional 5% of pay every year until an age 67 retirement;
- Defer retirement by a year; or
- Reduce their standard of living in retirement by an additional 9%.
What Can Employers Do?
Employers can promote the financial education, online advice, services, and tools that may already be available to employees. They should consider communications that respond to the current crisis, helping employees to recover and understand any changes available in their retirement plans. Providing and promoting these resources can help employees make informed decisions about their retirement contributions, investments, and any new loans or withdrawals.
Stabilizing Financial Wellbeing
As we emerge from this crisis, many employees will need to establish or beef up their emergency funds, reconfigure their budgets, resume paying off debt, and more before tackling their retirement saving, investing, and planning. Employers should consider whether they have the appropriate financial wellbeing initiatives in place to support their employees.
Planning for the Future
This crisis has highlighted the benefits of automatic features that put retirement plans on autopilot, as well as the lifetime income options that provide stable retirement income. The recently enacted SECURE Act2 enhanced the ability for plan sponsors to implement these features in their defined contribution plans. Defined benefit plans inherently incorporate many of these features. Employers should review the retirement readiness of their population in order to determine the most effective strategies that will enable employees to most efficiently and effectively save for retirement.
For additional ideas, see Aon's "Communicating About Retirement Benefits During Difficult Times".
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1 The CARES (Coronavirus Aid, Relief, and Economic Security) Act was a $2 trillion stimulus bill passed by Congress and signed into law in response to the economic impact of the global Coronavirus pandemic. This act included several key provisions for retirement plans.
2 The Setting Every Community Up for Retirement Ehnancement Act of 2019, or the SECURE Act, was signed into law on Dec. 20, 2019 and includes significant provisions for expanding retirement plans.