Unlike many workers, I get a statement every quarter from my defined contribution provider that includes a lifetime income projection. This number estimates how much monthly income I can buy from my retirement savings. And it is not a very big number.
That’s the point of the lifetime income illustration. Social Security and defined benefit plans are always presented in terms of income. How much are we going to get paid each month? You just run a quick formula and out pops a number. The number makes sense because we can relate it to our current expenses to see whether we have enough to retire comfortably. The defined contribution era means we have a bigger number that we need to turn into a smaller number. That requires math skills that most workers don’t have.
This inability to make sense of the number in their account statements is one of the reasons that the Department of Labor is moving forward with proposed rulemaking that would give plan participants a simple monthly income projection. Research suggests that these income projections will give workers much more realistic expectations about when they should retire and how much more they need to save. It also suggests that information isn’t a panacea and that assumptions may be overly optimistic.
Pensions are expensive. In a low-yield environment, it takes a very big number to replace an income using lump sum savings. As Stanford economist John Shoven has noted: “You can’t finance 30-year retirements with 40-year careers without saving behavior that is distinctly un-American.” Americans hoping for a financially secure retirement will likely need to save more and retire later. And seeing a big number on an account statement can lull a worker into a false sense of retirement readiness.
Many Americans don’t realize how much it costs to build a lifetime income in retirement. In a 2009 article, UC-Davis professor Victor Stango and Dartmouth professor Jonathan Zinman show how investors who are bad at comparing dollar amounts across time periods (they call it exponential growth bias) are far more likely to make incorrect financial decisions. If one could simply correct this bias by bypassing the financial calculation in the first place, some of these mistakes could be avoided.
That’s the reason the DOL is moving to add a lifetime income number to the lump sum amount reported in the traditional ERISA defined contribution disclosure statement. A DOL official noted that “adding this information to quarterly account statements lets workers know whether their savings are on track. For those saving too little, it provides a wake-up call to step up their savings.” You can’t dodge the reality that a gaudy six figure account balance provides a three figure monthly payment.
Understanding how little income you can buy with current savings is, of course, depressing. But the DOL wants workers to know that there’s a way out. The proposed rulemaking will also show workers how much higher their lifetime income could be if they saved a little more each month. So beat them down with a dose of reality and lift them back up with a new and improved savings plan that might just allow them to reach their retirement goals.
Will It Work?
I’m a big fan of information policy. Showing calories at restaurants is a great example. Knowing that fettuccine alfredo has more calories than a bacon burger helps me make better lunch decisions. Knowing how much income I’ll get from my 401(k) balance helps me make better savings decisions. Better information tools help me choose the diet and the savings amount that makes me the happiest.
A recent study by Stanford University economist Gopi Shah Goda and her co-authors looked at how providing lifetime income projections influenced savings behavior among 17,000 employees at the University of Minnesota. The authors split the sample into four groups—no information (a control), a group that just received general information on saving for retirement including how to sign up for the DC plan, a group that was shown how increased savings rates would allow assets to grow over time into a lump sum at retirement, and a group that received a lifetime income projection. This way the authors could see what type of information policy gave workers the greatest motivation to save.
Their finding showed that information policy works in general, but it doesn’t work for everyone and its aggregate impact isn’t huge. The income projection was most effective at changing savings rates and increasing the amount saved compared to general retirement information and information on projected aggregate savings balance. So giving workers a specific lifetime income estimate was more effective than policies like workplace retirement education. The increased likelihood of making a change was 29% when given a lifetime income projection and the amount increased by $1,150 per year. The not-so-great news was that, even after the intervention, only about 5% of employees participated in the optional DC plan, so the average increase among employees was about $85.