How much money do I need to retire?
It’s perhaps the most basic question in retirement planning. Yet there is no simple answer except “it depends.” One’s “number” depends largely on the
interest rate that will prevail at the time of retirement. The retirement cost can be defined as what an individual must pay to buy an income stream
sufficient to maintain their lifestyle in retirement—and interest rates will largely determine that cost.
Nearly a decade ago, PIMCO developed a framework for an outcome-oriented approach that defines retirement liability in real terms. It embodies a view that
has since been broadly adopted by the consultant community – namely, that the goal of retirement investing should be to maximize asset returns while
minimizing volatility relative to the retirement liability. A central challenge, though, has been calculating a liability that might be decades away.
The PIMCO retirement income cost estimate (PRICE) offers a straightforward and market-driven methodology for calculating the retirement liability. PRICE
uses a synthetic ladder of 20-year zero-coupon TIPS1 (Treasury Inflation-Protected Securities) as a proxy for historical and future retirement
cost. It’s an outcome-oriented approach that provides a powerful framework for both plan sponsors and participants:
Defining the target: How much will it cost to retire?
Often, the retirement cost is defined as what an individual must pay to buy an annuity that provides lifetime income sufficient to maintain her lifestyle
in retirement. Generally, this would be a CPI-adjusted single-premium immediate annuity (i.e., a real annuity); its cost would reflect the present value of
the stream of cash flows that stretches from retirement to the date of expected mortality. PRICE can estimate the cost of the retirement liability 2, both historically and prospectively. For more information on the rationale behind our approach, please see the 2007 Viewpoint,
“Stacy Schaus Discusses Defined Contribution Trends and Concerns with Target Date Investment Defaults,” PIMCO’s May 2015 DC Design, “Align the Design: Considering and Evaluating Target-Date Glide Paths,” and the June 2014 In Depth article, “Using a Real Liability to Assess Retirement Readiness and Inform Investment Decisions,” by Bransby Whitton and Klaus Thuerbach.
Historical retirement cost: How has the target moved?
Over the last decade, near-retirees have faced an escalating retirement price tag. Figure 1 shows the change for a typical participant with final pay of
$75,000 and a 30% real retirement income replacement goal (i.e., $22,500 CPI-adjusted annual income). From a 2008 low to a peak in 2013, the near-retiree
saw her retirement cost jump by about $150,000 – twice her final pay.
Because the retirement cost is calculated as the discounted present value of future cash flows, it is not surprising to see that it is inversely correlated
with interest rates.
Future retirement cost: How may the target move?
While understanding historical retirement costs is useful, workers and plan fiduciaries likely care more about
This is where PRICE can help. Figure 2 shows this cost based on a participant’s age, assumed retirement at age 65 and desired annual income stream, as of
June 2015. For a 25-year-old to buy an annual CPI-adjusted income stream of $50,000, for instance, the cost would have been $572,685. For participants age
45 or 65, buying the same real annual income would have cost $720,201 and $935,387, respectively. The discount rate differs depending on the years to
retirement, and given the current forward TIPS yield curve, the closer a participant is to retirement, the higher the retirement cost.
To consider the cost of different annual income streams, readers may use the PRICE multiplier shown in Figure 2. The PRICE multiplier is the cost of one
dollar of annual retirement income. It is calculated as the discounted present value of the 20-year zero-coupon TIPS ladder. It shows, for example, that
for a 25-year-old seeking $100,000 of real annual income, the purchase price was simply the annual retirement income times the multiplier, or approximately
Figure 3 shows the historical multiplier for retirement income cost for participants at 25, 45 and 65 years old (with an assumed retirement at age 65).
Since inception in February 2004, the annualized change in the PRICE multiplier is highest for the 40 years to retirement vintage at 4.54% and lowest for
the at-retirement vintage at 1.16%. This change is largely a function of the longer duration of PRICE and the declining rate environment. Over this period,
the PRICE multiplier had annualized volatility of 7.4% at retirement (i.e., age 65). PRICE multiplier volatility is much higher 20 and 40 years prior to
retirement at 20.8% and 35.3%, respectively.
Some participants may flip the “What’s my number?” question and ask, “How much income can I buy given my current savings?” Similarly, plan fiduciaries may
consider what percentage of income can be replaced based on the median balance in their DC plan.
The multiplier can help give insight to these questions as well. Figure 4 shows how much income (and what replacement rate) various levels of savings could
confer as of June 2015. For a 65-year-old with $500,000, the multiplier is 18.71, leading to a projected annual income of $26,727, or a 36% income
replacement rate, assuming her final pay is $75,000. If her accumulated balance increases to $700,000, the income replacement rate increases to roughly
Suggested approach for target-date benchmarking: the information ratio
Understanding both past and future retirement costs opens the door to benchmarking the plan’s investments. As the most prevalent DC investment default,
target-date funds rise to the top in requiring scrutiny and benchmarking. Given an objective of income replacement, we suggest DC plan sponsors examine
whether investments are on track to help participants meet their retirement income needs.
Consider two glide paths: the Market Average Glide Path3 and the Objective-Aligned Glide Path as shown in Figure 5. For both glide paths, we can
calculate and compare the excess return and tracking error relative to the PRICE.
Figure 6 illustrates that across all vintages the Objective-Aligned Glide Path has a higher excess return, lower tracking error and higher information
ratio. The at-retirement vintage shows a 0.79 information ratio for the Objective-Aligned compared with 0.57 for the Market Average Glide Path. This
assessment tells fiduciaries whether participants have been compensated for taking on the added risk, or tracking error, as measured by the information
ratio (which is the ratio of excess return to tracking error, both relative to PRICE). The downward slope in Figure 6 is explained primarily by the lower
excess return over PRICE of the farther-dated vintages (i.e., 20 or more years to retirement).The slope will change over time based on asset returns and
the interest rate environment.
Tracking DC account balance growth relative to PRICE
Plan sponsors may also want to evaluate how the default investment strategy performs relative to PRICE by taking into account the impact of savings.
Here’s how it works. Assume a participant at age 55 has accumulated $350,000 in retirement savings. Her personal savings rate and the employer match
from age 55 through 65 are 12% and 3.5% per year, respectively. Her salary at age 55 is $67,000 and the real annual wage growth rate is 1% per year. We
can calculate and compare the DC account balance that would have accumulated by investing in the Objective-Aligned Glide Path and the Market Average
Glide Path relative to PRICE.
Figure 7 illustrates that the average deviation from PRICE in the accumulated balance is positive for the Objective-Aligned Glide Path and negative for
the Market Average Glide Path between January 2004 and June 2015. Although both glide paths outpaced PRICE - they ended ahead of the retirement cost -
from the perspective of relative risk, the Objective-Aligned Glide Path had significantly lower tracking error in its accumulated balance4
than the Market Average Glide Path. Thus, the Objective-Aligned Glide Path had a positive information ratio of 0.64 in its accumulated balance, 5 whereas the corresponding ratio for the Market Average Glide Path was -0.26.
Another important consideration is the projected income replacement rate for the Objective-Aligned Glide Path and the Market Average Glide Path. In the DC Design article “Align the Design: Considering and Evaluating Target-Date Glide Paths,” our model projected that the probability of
achieving at least a 30% income replacement rate increases by almost 5 percentage points for the Objective-Aligned Glide Path compared with the Market
Average Glide Path.
As with reaching any goal, a concrete objective – knowing one’s number – can be helpful. PRICE can help in this regard. It can translate accumulated
account balances into future retirement income potential. And it can help plan sponsors benchmark target-date strategies.
Plan fiduciaries, especially those in the U.S., will want to keep a close eye on how their target-date funds have performed – and how likely they are
to deliver the retirement income plan participants need. PRICE is a simple yet powerful methodology to address this most fundamental of retirement
planning questions. We believe that by helping to keep track of – and projecting – one’s progress in real terms, it can be an invaluable aide for
individuals and plan sponsors alike.
We wish to thank Steve Sapra, Jim Moore and Bransby Whitton for their contributions to this article.
Zero-coupon U.S. TIPS do not exist but Haver Analytics created a zero-coupon U.S. TIPS yield curve based on Federal Reserve data and calculation
To evaluate retirement cost we calculated the present value of a 20-year zero-coupon TIPS ladder using the TIPS yield curve provided by Haver
Analytics. For example, if an individual needs $50,000 annually, the cost
to buy that income stream was $902,094 in 2013 and $936,051 in 2014.
The Market Average Glide Path is constructed by MarketGlide and is an average of the 40 largest target-date strategies in the market.
Tracking error in accumulated balances is calculated as the standard deviation of the dollar difference between the accumulated account balance of the
glide paths (Market Average and Objective-Aligned) and the accumulated account balance of PRICE.
The information ratio in accumulated balance is calculated as the average difference between the accumulated account balance of the glide paths and the
accumulated account balance of PRICE divided by tracking error in accumulated balance.