May 2012White paper

Dominant variables: Keys to success in defined contribution savings

Edmund F. Murphy III Director, Defined Contribution Services

Key takeaways

Access to workplace savings plans is a decisive variable for retirement readiness We see 10%+ deferral rates as a critical threshold for determining retirement success Using an advisor and having a formal financial plan can have a major impact on retirement savings

Putnams thinking on defined contribution policy rests on the view of our CEO, Bob Reynolds: The best measure of the success or failure of any retirement system, plan, or strategy is its ability to reliably replace pre-retirement income for life. To provide a sense of the progress we are collectively making toward this goal, Putnam joined with Brightwork Partners last year to conduct a comprehensive survey of nearly 4,000 working Americans retirement readiness. The survey took into account a wide range of variables, including access to workplace savings plans, individuals savings behavior, wage inflation, home ownership and business equity, total assets held, and projected Social Security benefits. The survey aimed to determine a Lifetime Income Score (LIS) defined as the percentage of pre-retirement income a person or cohort is on track to replace. Overall, we found that when we include Social Security, working Americans are on track to replace roughly 65% of their current incomes in retirement. In our view, this falls somewhat short of what individuals will likely need, but it is close enough for most people to potentially reach a secure retirement, provided they have three things: access to a plan, high deferral rates, and the help of a financial advisor. In short, our survey suggests that we need to set a new and higher bar for our industry.

This paper is adapted from an address delivered by Edmund Murphy at the Employee Benefit Research Institute 2012 Policy Forum, Washington, D.C., on May 10, 2012.
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MAY2012| Dominant variables: Keys to success in defined contribution savings

Access to workplace savings is vital Our study disclosed detailed findings that hold powerful implications for providers, plan sponsors, and public policymakers. The first is that access to and active participation in a workplace savings plan make a dramatic difference on retirement readiness.

Those who have access to plans and do take part in them are on track to replace 91% of their pre-retirement income up from 87% in 2011 when we include Social Security (Figure 1). Those who are eligible but choose not to participate in a plan are likely to replace just 56% down from 65% in 2011.

Figure 1. LIS increases with plan eligibility and participation

2012 91% 87% 2011

Lifetime Income Score

65% 56% 41% 46%

Eligible and active in DC plan

Eligible, but not active in DC plan Employer plan status

Ineligible for employer plan

The Putnam Lifetime Income Survey, with research methodology provided by the Putnam Institute, was conducted online by Brightwork Partners and completed in the fourth quarter of 2011. The survey of 3,958 working adults age 18 to 65 was weighted to U.S. Census parameters for all working adults.

Those who lack access to an employer plan are on track to replace just 41% of pre-retirement income, down from 46% in 2011 even when we include Social Security. This is only slightly more than half the income prospects of those who have access to and participate in workplace savings plans. This dire statistic appears to threaten a precipitous decline in postretirement lifestyles for workers who lack access to retirement savings on the job.

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Deferral rates are the prime variable Among active participants, the most important variable affecting lifetime income scores is the rate of deferral. Compared with our initial survey, total household retirement savings inside and outside workplace retirement plans increased from 12.1% of income to 14.2% by year-end 2011. The majority of this increase came from households eligible to participate in workplace retirement plans. These households increased their DC deferral rate from 8% to 9% on average and increased their retirement savings outside their workplace plan from 8% to 10%. What is most striking here is that the survey found a sizeable subset of participants who have chosen to defer at rates of 10% or more. Factoring in Social Security, these people are on track to replace 145% of their pre-retirement income success by any measure (Figure 2).

Significantly, this score does not represent a small minority of participants. In fact, Brightwork Partners estimates that roughly 19 million workplace savings plan participants today fall into this category of savers, and this population crosses all levels of income. One of the most encouraging findings in our initial survey was that households in the top quartile (replacing 100% or more of income) and the bottom quartile (replacing less than 45% of income) had exactly the same average annual income of $93,000. The difference was that one group had saved and invested, while the other had not. While our most recent data suggest a widening gap between lower- and higher-income households, we believe the key point is that savings behavior specifically deferral rates is not dependent on income levels.

Figure 2. Deferral rates were the prime variable for lifetime income success

145% 124% 2012 2011

Lifetime Income Score

85%

84% 65% 54%

61%

58%

10%+

4% < 10%

0.01% < 4% DC plan deferral rate

0%

The Putnam Lifetime Income Survey, with research methodology provided by the Putnam Institute, was conducted online by Brightwork Partners and completed in the fourth quarter of 2011. The survey of 3,958 working adults age 18 to 65 was weighted to U.S. Census parameters for all working adults.

MAY2012| Dominant variables: Keys to success in defined contribution savings

Figure 3. More is more: The qualitative impact of changing deferral rates

$400,000 10% deferral: $381.4K 350,000 3% escalating to 10% 300,000 $320.3K OR 8% deferral $322.3K Account balance 250,000 6% deferral: $263.1K 200,000 4% deferral: $175.4K 150,000 3% deferral: $131.5K 100,000 50,000 0 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 11

For illustrative purposes only. Not indicative of the performance of any fund or product. Assumes a portfolio of 25% equity [10% large-cap growth (Russell 1000 Growth Index), 10% large-cap value (Russell 1000 Value Index), 5% small cap (Russell 2000 Index)]; 5% international equity [MSCI EAFE Index (ND)]; 60% U.S. bonds (Barclays Aggregate Bond Index); and 10% money market (BofA Merrill Lynch U.S. 3-Month Treasury Bill Index). It is not possible to invest directly in an index.

The impact of higher deferrals To illustrate the critical role played by deferral rates in retirement savings, we can consider how a 401(k) saver would have fared over a 30-year time frame, from 1982 through 2011. Lets assume our saver well call him John was age 28 in 1982, with an income of $25,000 that rose by 3% annually. Thirty years worth of consistent 3% deferrals into a balanced, multi-asset portfolio (see note to Figure 3) compounded at historical index rates for stocks, bonds, and cash would yield John just north of $131,000 at retirement in 2012. But what if we adjust this base case for John by changing his deferral rate? The differences are stark (Figure 3). An increase of one percentage point in career deferral rates would add roughly $45,000 to Johns balance at retirement. And higher deferral rates such as an 8% rate or a 3% initial rate that escalates by one percentage point

per year until it reaches 10% would compound to more than $320,000 by year-end 2011. In terms of gains over the base case of a $131,000 nest egg, each of the higher deferral rates would have produced substantial additional savings (Figure 4). Notably, too, a gradual increase from 3% to 10% would have produced something very close to a flat 8% deferral an interesting view on the value of auto-escalation features offered by many 401(k) plans. The best case, of course, is illustrated by the 10% deferral rate, which would have netted John roughly a quarter of a million dollars more. In our analysis, deferral rates have the greatest impact on individuals prospects for retirement success.

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Figure 4. Deferral rules: Gains over the base case from five variable deferral rates
$249.9 Incremental impact over base case ($ thousands)

$190.8

$188.8

$131.6

$43.9

4% deferral

6% deferral

8% deferral

QACA reaching 10%

10% deferral

For illustrative purposes only. Not indicative of the performance of any fund or product. It is not possible to invest directly in an index.

Figure 5. Advisors and written plans had major impact

89% 82%

2012

2011 117% Lifetime Income Score 123%

Lifetime Income Score

58%

61%

58%

Use a paid advisor

Do not use a paid advisor

Do not have a financial plan

Have a financial plan

Have a plan that considers health care

The Putnam Lifetime Income Survey, with research methodology provided by the Putnam Institute, was conducted online by Brightwork Partners and completed in the fourth quarter of 2011. The survey of 3,958 working adults age 18 to 65 was weighted to U.S. Census parameters for all working adults.

MAY2012| Dominant variables: Keys to success in defined contribution savings

Financial advisors lift retirement readiness Another key finding from the second wave of our retirement readiness survey is that the use of a financial advisor correlates with significantly higher scores on our Lifetime Income metric. Indeed, those who use advisors had median scores that were 30 points higher than those who did not (Figure 5). Having a formal written financial plan also doubles the median score, from 58% to 117%. Conclusion At Putnam, we draw several policy-related conclusions in connection with the foregoing study and analysis. First, Social Security provides a vital baseline for all income groups. It is indispensable for low-income workers, is vital for middle-income folks, and has serious value well up the income scale even for the affluent. This is why Putnam has advocated for bipartisan action to ensure the systems long-term solvency and dispel the aura of uncertainty that undermines confidence in Social Security today. Second, access to workplace savings plans is a decisive variable for retirement readiness. This is why we support passage of the auto-IRA legislation proposed in Congress, and it forms the basis of our opposition to any effort to undercut savings incentives in the tax code. In short, we believe the latter could discourage employers from offering plans and send millions of low- and middle-income workers toward retirement with virtually no assets.

Third, we think the DC industry needs to refocus its energies on participants lifetime income potential and advise them of their progress toward their pre-retirement income-replacement goals. Individual funds performance within plans does matter. But it is only one of many variables at work, including plan design, diversification, rebalancing, age-based strategies, and deferral rates. And of all these variables, deferral rates are by far the most powerful factor. We encourage financial providers, plan sponsors, advisors, and policymakers to adopt 10%+ deferral rates as the new norm for retirement success even if we must begin at lower rates and count on auto-escalation to climb the ladder to success. And while we think 10%+ should be a key goal, 10% really should be viewed as a floor rather than a ceiling. Anything less than 10%, in our view, is just not good enough.

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The Putnam Lifetime Income Score SM represents an estimate of the percentage of current income that an individual might need to replace from savings in order to fund retirement expenses. For example, consider an individual, 45 years old, with an income of $100,000 per year. A Lifetime Income Score of 64% indicates that the individual is on track to be able to generate $64,000 in retirement income (in todays dollars), i.e., 64% of current income. This income estimate is based on the individuals amount of current savings as well as future contributions to savings (as provided by participants in the survey) and includes investments in 401(k) plans, IRAs, taxable accounts, variable annuities, cash value of life insurance, and income from defined benefit pension plans. It also includes future wage growth from present age (e.g., 45) to the retirement age of 65 (1% greater than the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W)) as well an estimate for future Social Security benefits. The Lifetime Income Score estimate is derived from the present value discounting of the future cash flows associated with an individuals retirement savings and expenses. It incorporates the uncertainty around investment returns (consistent with historical return volatility) as well as the mortality uncertainty that creates a retirement horizon of indeterminate length. Specifically, the Lifetime Income Score procedure begins with the selection of a present value discount rate based on the individuals current retirement asset allocation (stocks, bonds, and cash). A rate is determined from historical returns such that 90% of the empirical observations of the returns associated with the

asset allocation are greater than the selected discount rate. This rate is then used for all discounting of the survival probability-weighted cash flows to derive a present value of a retirement plan. Alternative spending levels in retirement are examined in conjunction with this discounting process until the present value of cash flows is exactly zero. The spending level that generates a zero retirement plan present value is the income estimate selected as the basis for the Lifetime Income Score. In other words, it is an income level that is consistent with a 90% confidence in funding retirement. It is viewed as a sustainable spending level and one that is an appropriate benchmark for retirement planning. The survey is not a prediction, and results may be higher or lower based on actual market returns.

MAY2012| Dominant variables: Keys to success in defined contribution savings

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