Chapter 2
Doubts about the 70 Percent Retirement Income Target

You will no doubt have heard that one's retirement income target should be 70 percent of final pay, if not more. This widely accepted target was already common knowledge more than 30 years ago when I was starting out in the pension consulting industry.

As a pension actuary, I have spent much of my career helping organizations establish defined benefit pension plans for their employees. The design process usually started with the 70 percent income target from which one subtracted the portion that was deemed to be the employee's individual responsibility. The balance would then be spread over 35 or 40 years to determine a formula for the amount of pension earned each year. In the case of public-sector plans, for example, the employee was not expected to shoulder any individual responsibility, so it was a matter of dividing 70 percent by 35 years to get an annual pension accrual of 2 percent of final earnings for each year or service.1

When a rule of thumb is so integral to the process of determining the pension for millions of participants, you would think it would be unassailable. Over my career, the 70 percent pension target was rarely challenged, and certainly not by a young actuary like me when I was first starting out in the business. Indeed, no one to my knowledge seriously questioned the 70 percent rule until the 1990s when a few voices in the wilderness, led by pension actuary Malcolm Hamilton, made themselves heard.

Those voices were drowned out, though, as constant reinforcement by banks, insurance companies, financial planners, and investment advisors about the need to save enough to reach the 70 percent target kept the rule alive. It continues to underpin virtually every public-sector pension plan in Canada and the United States, and surely what was built to serve millions of civil servants could not be wrong. Or could it?

Niggling Doubts

For me, the doubts started to creep in a little over a decade ago. In the case of workers who earned above average income, a 70 percent target made less sense the more I thought about it. Not that there was any one smoking gun. My misgivings stemmed from a number of sources.

For starters, consider how a typical hard-working middle-income married couple divides up their paycheck. We will assume that they:

• are both working,
• raise two children,
• buy a house and spread the mortgage payments over their working careers,
• avoid going into debt, other than the mortgage,
• save 7 percent to 10 percent of pay for retirement every year, in addition to making Social Security contributions, and
• retire at 65.

If we broke down their gross income year by year into the major categories, it would look something like Figure 2.1.

Figure 2.1 Breakdown of Expenditures in a Steady Saving Scenario

After paying for all the big-ticket items including taxes, the percentage of their gross pay that remains for personal consumption dips as low as 25 percent during their 30s and never gets higher than 45 percent, something that occurs only in their last 10 years of working. If they wanted to continue spending at the same rate in retirement, they would need retirement income of 50 percent of gross pay to produce after-tax income of 45 percent. That is 20 percentage points less than the conventional target, so something appears to be amiss! Perhaps this example does not fully capture reality, so let us consider other evidence that puts 70 percent into question.

Fewer private-sector workers remain covered by a group retirement arrangement in their workplace, especially in Canada. That arrangement could be either a defined benefit (DB) pension plan or a defined contribution (DC) plan. In the United States, about half of all private-sector workers have no pension coverage at all. In Canada, the figure is closer to 70 percent. That's right. Between 5 and 7 private-sector workers out of 10 have no formal pension coverage other than Social Security, and that is meant to cover only the most basic spending needs. For anyone earning much more than the average wage, the gap between the 70 percent target and the pension from Social Security would be so huge that it makes a disastrous retirement seem inevitable. Why, then, were we not reading more stories in the papers about former middle-income workers being reduced to penury in their retirement years? Yes, the newspapers do report often on a retirement crisis, but almost always from a high-level, abstract point of view, not how Joe the retired engineer is living in a shabby bachelor apartment and eating mac and cheese.

Defined benefit versus defined contribution plan

A defined benefit (DB) pension plan provides a pension benefit that is defined by a formula based on length of service and possibly earnings. The pension does not depend on how the investments in the pension fund perform. The benefit is a predictable amount, at least in terms of earnings. An example is a plan that provides a pension of 1 percent of average earnings in the last 5 years of employment for each year of service.

In a defined contribution (DC) pension plan, the pension benefit is whatever income can be generated after retirement with the account balance that accumulates over the employee's career. Hence, the benefit is uncertain and the employee takes the risk. The employer and often the employees as well contribute a well-defined amount such as 4 percent of pay. A separate account balance is maintained for each employee, who can usually select the funds to invest in. Examples of DC plans are 401(k) plans in the United States and DC pension plans or group RRSPs in Canada.

Social Security

The term Social Security in this book includes basic government pensions whether in the United States or in Canada. A fuller definition is given in Appendix B.

In addition, more workers who are lucky enough to have any workplace pension coverage at all are now covered by DC plans. Actuaries were dismayed when DC plans first took hold about 25 years ago because those plans did not seem to meet the pension adequacy test. The employer contribution to DC plans is typically only half what it is for defined benefit pension plans. This was not nearly enough, the actuaries said, and that was at a time when future investment returns were expected to be in the 8 percent to 10 percent range, not the paltry 4 percent to 6 percent as is the case today. The typical DC plan, combined with Social Security, comes nowhere close to reaching the 70 percent target.

The consensus was that once these DC plans had been around long enough for a significant number of workers to retire from them, their shortcomings would become self-evident. Actuaries referred to them as ticking time bombs. Yet, here we are, after more than 25 years of living in a DC world, after the perfect storm of 2001-2002 that decimated account balances in DC plans, and after the worst financial meltdown since the Great Depression, and DC plans continue to thrive.

There were other indications that the 70 percent target was unrealistically high. For instance, I have tried more than once to poll retirees in large pension plans to learn more about their spending patterns and financial situation 10 or 20 years after retirement. The intent was to determine what portion of their pension they give as gifts to other family members, how much they continue to save, and what they spend on consumer-durables such as furniture, big appliances, or cars.

The sponsors of the plans that I targeted were sympathetic to the purpose of my investigation, but there was a problem. They needed the consent of the pension plan's retiree association to proceed but the leaders of the association would invariably stonewall the request. Apparently, they were afraid that the data gathered would be used by the employer to justify granting smaller pension increases in the future.

It would seem the retirees knew they had a good thing going and did not want to jeopardize it by disclosing their financial situation. Had their pensions been deficient, which they should have been since most of them retired on considerably less than 70 percent, one would have thought the retirees would welcome a survey to make their plight better known, but this was never the case.

A survey commissioned by the Canadian Institute of Actuaries asked people both before and after retirement how confident they felt about their financial future. You would think the retirees would feel less confident than the pre-retirees because, having retired with retirement income less than 70 percent, they would now be in full panic mode. The survey result, however, showed just the opposite. Only 44 percent of the pre-retirees were confident about their financial future versus 62 percent of those already retired. Among retirees who had paid off their mortgages, 74 percent were confident. In case you are wondering if the people surveyed were unusually affluent, at least 57 percent said they had total investments of under $250,000.2 Could it be that the retirees learned from actual experience what pre-retirees could not yet know-that they would make out just fine with less than 70 percent?

Another survey, this one conducted by Statistics Canada, asked recent retirees how their financial situation had changed in retirement versus the year before retirement.3 Of those retirees, 54 percent said it was "about the same," 13 percent said...