Investing for Retirement in a Low Returns Environment

Catherine Reilly, CFA

Alistair J. Byrne, CFA, PhD, IIMR

May 4, 2017

This material is solely for the private use of Pensions Research Council Conference and is not intended for public dissemination.

DC-3819

Investing for Retirement in a Low Returns Environment

• Retirement saving is getting more challenging

• Rising longevity

• Lower expected returns

Boomers: Rising longevity; some exposure to DB; relatively higher realised returns Millennials: Rising longevity; no DB; relatively lower expected future returns What plausible actions can millennials take to enjoy retirement security? Our analysis:

• Takes account of potential achieved and expected future returns

• Reflects typical pillar one entitlements

• Adjusts for income effects in replacement rates, longevity and social security entitlements

2DC-3819

Source: SSGA calculations based on realized investment returns and ISG long term asset class forecasts and UN population projections https://esa.un.org/unpd/wpp/Download/Standard/Population/.

The Saver’s Dilemma — Rising Life Expectancy and Lower Returns

US Life Expectancy at Different Ages Historical and Expected Market Returns

0

5

10

15

20

25

1 9

5 0

-1 9

5 5

1 9

5 5

-1 9

6 0

1 9

6 0

-1 9

6 5

1 9

6 5

-1 9

7 0

1 9

7 0

-1 9

7 5

1 9

7 5

-1 9

8 0

1 9

8 0

-1 9

8 5

1 9

8 5

-1 9

9 0

1 9

9 0

-1 9

9 5

1 9

9 5

-2 0

0 0

2 0

0 0

-2 0

0 5

2 0

0 5

-2 0

1 0

2 0

1 0

-2 0

1 5

2 0

1 5

-2 0

2 0

2 0

2 0

-2 0

2 5

2 0

2 5

-2 0

3 0

2 0

3 0

-2 0

3 5

2 0

3 5

-2 0

4 0

2 0

4 0

-2 0

4 5

2 0

4 5

-2 0

5 0

2 0

5 0

-2 0

5 5

2 0

5 5

-2 0

6 0

65 75 85 95

11.7%

7.7%

6.1%

3.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

US Large Cap Equities Investment Grade Bonds

1976–2016 Forecast

Source: UN Population Projections, historical return data for S&P 500 and Bloomberg Barclays Aggregate Index, forecasts ISG December 2016 Long-term (10+ years) asset class forecasts.

3DC-3819

Impact of Lower Investment Returns => Lower DC Replacement Rates for the Same Savings

In a prolonged environment of depressed investment returns, younger cohorts may not be able to rely exclusively on returns to do the job for them

Expected Replacement Rate at Age 65

We used identical assumptions regarding:

• Contribution rate: 9% from age 22

• Wage growth: 2%

• Composition of investment portfolio: 80:20*

We use a sustainable drawdown rate based on cohort life expectancy to calculate the replacement rate

• Low return expectations mean that identical savings behaviour provides younger cohorts with much less generous replacement rates at retirement

183%

49%

28%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

60 45 25

Ex p

e ct

e d

R e

p la

ce m

e n

t R

at e

Age in 2016

Source: SSGA calculations based on realized investment returns and ISG long term asset class forecasts and UN population projections https://esa.un.org/unpd/wpp/Download/Standard/Population/. For illustrative purposes only. * The hypothetical portfolio we use for this illustration allocates 80% to the S&P500 Index as a proxy for US Large Cap Equity, and 20% to the Barclays Bloomberg Aggregate Index as a proxy for Investment Grade bonds. Consequently, the hypothetical portfolio uses the market return forecasts illustrated on the previous slide.

4DC-3819

Younger Cohorts would have to Work Longer and Save More

Working longer has a powerful impact Saving more helps too — but not as much!

49%

35%

28%

71%

51%

42%

108%

77%

62%

0%

20%

40%

60%

80%

100%

120%

45 35 25

R e

p la

ce m

e n

t R

at e

( 9

% c

o n

tr ib

u ti

o n

)

Age in 2016

Retire at 65 Retire at 70 Retire at 75

46%

33%

27%

62%

44%

36%

77%

55%

45%

0%

20%

40%

60%

80%

100%

120%

45 35 25

R e

p la

ce m

e t

ra te

( ag

e 6

5 r

e ti

re m

e n

t)

Age in 2016

Retire at 65, save 9% Retire at 65, save 12% Retire at 65, save 15%

Source: SSGA calculations based on realized investment returns and ISG long term asset class forecasts and UN population projections https://esa.un.org/unpd/wpp/Download/Standard/Population/. The illustration above assumes 2% wage growth during employment, an investment portfolio composed of 80% US large cap equities and 20% the Bloomberg Barclays aggregate index. Return forecasts were generated using MonteCarlo simulations based on ISG long-term return and volatility forecasts of 6.1% long term returns and 18% standard deviation for US Large-cap equities and 3.0% long term returns and 5.5% standard deviation for investment grade bonds.

5DC-3819

Income Effects — Required Replacement Rates versus Social Security

Low income earners have higher replacement rates from Social Security

Retirement challenges differ by income cohort

49%

61%

36%

45%

30%

37%

24%

30%

0%

10%

20%

30%

40%

50%

60%

70%

65 70

R e

p la

ce m

e n

t R

at e

Retirement Age

Low ($21k) Medium ($47k) High ($75k) Max ($114k)

Low income earners:

+ High replacement rate from social security

- May need close to 100% replacement rate to survive

+ Have lower life expectancy (fewer years in retirement to finance) - May have less capacity for later life work

- Fewer other financial assets

Source: SSGA calculations, based on Social Security replacement rate data consistent with the 2014 OASDI Trustees’ Report (http://crr.bc.edu/data/frd/ point 1), Social Security Online ‘Effect of Early or Delayed Retirement on Retirement Benefit’, (https://www.ssa.gov/OACT/ProgData/ar_drc.html). Benefit adjustments calculated for persons born in 1960 or later.

6DC-3819

Starting Early and Saving Consistently are Key to Successful Saving

Even in a low returns environment, younger generations can achieve reasonable outcomes by starting early, saving consistently and retiring at 70

7%

11%

13%

15%

0%

4%

6%

8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Low Medium High Max

To ta

l c o

n tr

ib u

ti o

n r

at e

Income group

Retire at 65 Retire at 70

Source: SSGA calculations based on realized investment returns and ISG long term asset class forecasts and UN population projections https://esa.un.org/unpd/wpp/Download/Standard/Population/. The illustration above assumes 2% wage growth during employment, an investment portfolio composed of 80% US large cap equities and 20% the Bloomberg Barclays aggregate index. Return forecasts were generated using MonteCarlo simulations based on ISG long-term return and volatility forecasts of 6.1% long term returns and 18% standard deviation for US Large-cap equities and 3.0% long term returns and 5.5% standard deviation for investment grade bonds.

7DC-3819

Required total contribution rate for a 25-year-old to achieve a 70% replacement rate (including SS) at retirement by income group

Late Starters Should Plan on Working Until 70

Late starters need to make significant efforts to improve their retirement readiness. Postponing retirement also improves the replacement rate from Social Security.

9%

14%

4%

7%

14%

21%

6%

11%

19%

27%

8%

15%

0%

5%

10%

15%

20%

25%

30%

45–65 45–70 55–65 55–70

D C

R e

p la

ce m

e n

t R

at e

Starting age of retirement saving and retirement age

10% Contribution Rate 15% Contribution Rate 20% Contribution Rate

Source: SSGA calculations based on realized investment returns and ISG long term asset class forecasts and UN