Three Quarters of Americans Aren’t Putting Enough into Their 401(k)s

So, has this fear actually pushed Americans to save adequately for their golden years? Prior research has come to mixed conclusions.

In a new study, Enrichetta Ravina, visiting associate professor of finance at Kellogg, takes a fresh look at retirement coffers. Along with coauthors Francisco Gomes of the London Business School and Kenton Hoyem and Wei Hu, both of Edelman Financial Engines, Ravina set out to determine whether Americans are saving enough to maintain their standard of living later in life.

The researchers don’t emerge with hopeful news: nearly three-fourths of American workers with defined contribution plans like 401(k)s, they find, are not saving enough.

The scope of the shortfall was even greater than Ravina expected—and it is also more dramatic than what other studies have found. The implications of the savings gap could be major. At an individual level, financial instability in retirement could mean being unable to pay for medical bills or to leave an inheritence to relatives. But at a societal level, having such a large proportion of retirees in this position is also very worrisome, Ravina says.

“This is going to be a problem for the country in general,” she says, noting that demands on federal entitlement programs like Social Security could intensify dramatically—a troubling prediction, given that those benefits are set to be fully tapped by 2034. “We will need to find ways to offer a minimum sustaining level of income to these retirees.”

The Challenge of Studying Retirement Savings

In the study, the researchers focused on workers in defined contribution plans, in which employees and employers both make regular contributions to an investment account. Such plans are fast becoming the most common retirement plan in the U.S. The question at the heart of their research: What portion of these workers will have enough money to maintain the same standard of living once they turn 65?

Many previous studies exploring this question rely on surveys that ask future retirees how much they’re saving for life after work. But, Ravina says, surveys often yield inaccurate findings—blame faulty memories, a lack of understanding about finance and investing, and the desire to put a positive spin on personal information.

Ravina and colleagues eschewed surveys for a more technical approach: applying mathematical models and simulations to a large sample of U.S. workers.

The team had access to a large anonymized dataset that offered an unvarnished glimpse into how people working at 296 firms saved for retirement over time. That dataset, which came from a financial management company, included detailed data on employee age, salary, and tenure with the company, as well as 401(k) account balance, portfolio allocation, and other attributes.

This granular data allowed the researchers to understand how people with specific characteristics tended to save over time, Ravina says. “If people behave like the average person in their demographic going forward, what is the chance that they will have enough money for retirement?”

The researchers also made a critical assumption: that people are not perfectly rational. Most studies that use such models tend to assume that Americans will make rational financial choices, Ravina says, such as taking full advantage of their housing equity during retirement (say, by downsizing or taking out a reverse mortgage), or spending less during their working years if they don’t anticipate having enough savings. But based on her own work in the field of behavioral economics, Ravina had her doubts about how well these assumptions reflected reality.

“We all make mistakes, we all forget, we all tend to have inertia,” Ravina says. “We don’t update or change our investments as much as we should.” Thus, in their models, the researchers relaxed the assumption that people saving for retirement behave perfectly rationally, and instead analyzed how the real people in their dataset actually acted.

Inadequate Investments

The next step was to estimate workers’ current standard of living. To figure out how much a worker’s lifestyle cost prior to retirement, the researchers looked to the Consumer Expenditure Survey. This allowed them to estimate the annual spending level of each individual in their dataset based on their age and salary.

The upshot: only about one in four of the 300,000 workers analyzed saved enough to afford their former standard of living upon retirement.

Furthermore, the particulars of a company and its retirement plan appeared to have a major impact on future savings. The workers who ended up with the most retirement wealth in the study’s simulations tended to be employed by companies that were older and private, possibly because these companies also tend to be more established and have higher profits on average.

And, not surprisingly, workers tended to fare better when they had worked for companies that paid higher salaries and offered more retirement matching.

Workers also benefit from the slow and steady accumulation of retirement contributions. The study found that just one percentage point increase in a worker’s monthly contribution rate boosts retirement wealth at 65 by more than $30,000.

Where someone lived also impacted their ability to maintain their previous standard of living after retirement: those residing in areas with higher financial literacy and a higher proportion of college-educated people were more likely to be in good financial shape upon retirement.

The researchers’ models also pinpointed some of the specific behaviors that lead people to fall short. Among the chief culprits were “leakages.” Currently, U.S. law allows for penalty-free withdrawals from retirement accounts starting at age 59½, even if the individual has not yet retired.

The researchers find some 9.5 percent of a workers make a withdrawal by age 60—and that doing so reduces total retirement savings by an average of 11.5 percent.

Policies to Promote Savings

These retirement shortfalls are likely to be compounded by a widespread change quietly underway across the U.S., Ravina says.

Employees are increasingly being shuffled away from defined benefit pension plans, in which companies guarantee a certain level of pension benefits, and into defined contribution plans, like 401(k)s, which place retirement-savings decisions more squarely in the hands of the employee. According to the Bureau of Labor Statistics and the Department of Labor, the percentage of U.S. workers enrolled in a defined benefit plan fell from 38 to 20 percent between 1980 and 2008, while the portion of employees in a defined contribution plan rose from 8 percent to 31 percent over the same period.

“As a result of this shift, people who have low financial literacy or don’t think a lot about the future end up falling short,” Ravina says. “Defined contribution plans open up that possibility.”

However, it is not all bad news. The results suggest some ways that policymakers could promote better savings behavior.

Stopping leakages could be a first step. Ending penalty-free withdrawals before retirement age, the researchers found, would increase wealth at age 65 by 15 to 20 percent for the average American.

In the absence of policy changes, Ravina says individuals enrolled in defined contribution plans can shore up their retirement savings by adhering to best practices: take full advantage of any contribution matching plan your company offers, start saving for retirement as soon as you start working, and avoid withdrawing money from retirement accounts if possible.

Furthermore, she says, workers should not cower away from a volatile stock market, especially if they are more than 15 years away from retirement. Ravina points out that in the study, individuals who invested in equities retired with 10 percent more wealth than those who relied on safer investments like bonds—even after suffering substantial losses in the Great Recession.

Perhaps most importantly, Ravina stresses, the results reveal a need for better financial literacy. She believes that too many workers postpone decisions about retirement savings and investment out of confusion and intimidation.

“It’s pretty scary; this is a system where people are increasingly on their own,” Ravina says. “This is something they need to know about.”