Crain,
This is a very interesting study that makes some good broad-brush points. It is important to remember, however, that Ernst & Young did the study (was paid to do it) by Americans For Secure Retirement. Americans For Secure Retirement is an organization whose goal is to promote the use of life annuities for retirees. It's good to keep that in mind.
(Forum members who haven't read the study can download the PDF file here: http://www.paycheckforlife.org/uploads/2008_E_Y_RRA.pdf
The most important broad-brush point is that households depending on Social Security and investment income for all of their retirement spending are more vulnerable than households that have Social Security, investment income, and a defined benefit pension. Since a DB pension is, in effect, a life annuity those who have them have two lifetime income sources, not just one. So less weight is put on the investment portfolio.
A good deal of research has shown that making a life annuity part of your retirement portfolio can enhance the odds of portfolio survival significantly. Here's a link to my 2002 column about research by Veres, Ameriks, and Warshawsky showing this:
http://assetbuilder.com/blogs/scott_burns/archive/2002/02/26/Annuity-Income-May-Increase-Portfolio-Survival.asp
A similar study at Ibbotson Associates came to the same conclusion.
The E&Y study finds that a $75,000 a year couple with a DB pension has a 31 percent chance of outliving its financial assets while a similar couple without a DB pension has a 90 percent chance. Big difference!
The couple without a DB pension can reduce its probability of outliving its assets to 5 percent by cutting its pre-retirement standard of living by a whopping 38 percent. It will only require a 14 percent cut for the couple with the DB pension to do the same thing.
I think those are reasonable results for their framework.
Then what's wrong?
Simple, the Ernst & Young study starts with the same flaw that afflicts most retirement planning. It assumes that you need to replace a certain percent of your pre-retirement income to sustain your standard of living. In fact, the vast majority of human beings (those who have had children or have had significant debt obligations during some of their adult life!) have never had a standard of personal consumption remotely close to the usual rules of thumb about replacement income.
The typical rule of thumb says that you need to replace 70 to 85 percent of your pre-retirement income to sustain the same standard of living in retirement. This figure includes income tax payments. The Ernst and Young study assumes that you need to replace 59 to 71 percent of pre-retirement earnings PLUS taxes to sustain the same standard of living in retirement. Adjust for the tax factor and their figure is somewhat lower than the conventional wisdom.
When you use the consumption smoothing approach to financial planning--- the approach that Kotlikoff and I use in "Spend 'til the End" (Simon & Schuster, June 2008)--- and calculate your ADULT consumption after factoring out spending on children and debt service--- the consumption you have to replace comes to a much smaller portion of your pre-retirement income. You can get the general idea by reading this column:
http://assetbuilder.com/blogs/scott_burns/archive/2008/06/06/the-n-factor-and-retirement-planning.aspx
Use a realistic, consumption smoothing based, replacement rate--- the equivalent of about 40 to 60 percent on the Ernst & Young scale, and far fewer people will be running out of money because their consumption spending will be smaller to start with. As the study points out, reduce spending and the probability of having your assets survive as long as you do increases.
Does this mean everyone in America is going to live happily ever after and never go broke? Not at all. It just means that Ernst & Young may be overstating the problem in one sense (income to be replaced) and understating it in another. In Appendix B of the study they lay out their methodology and assumptions, disclosing on page 16 that they assume mutual fund management expenses of only 64 basis points.
As I have pointed out many, many times in columns, fees matter. They matter while you are accumulating. And they get really important when you are distributing. If Ernst & Young calculated their failure rates based on total financial service fees of 1.5, 2.0, or 2.5 percent many more households would fail.
Scott
