The Retirement Plan Solution: The Reinvention of Defined Contribution

Chapter 3. Retirement Is Expensive

Typical savings rates in a DC plan are around 10 percent of earnings, 7 percent coming from employees and 3 percent from employers.^[25] Is this consistent with an aspiration for the plan to replace a significant portion of an individual's salary in retirement? How much does a retirement system require in terms of contributions if it is to satisfy the expectations of workers and, indeed, of society? Those are the questions addressed in this chapter. Based on a simple model of wealth accumulation over a working lifetime and wealth decumulation in retirement, we will explore the interaction of savings and investment growth and reach two main conclusions. The first conclusion is that income replacement in retirement is expensive. The second conclusion—one that is far less widely recognized—is that we cannot with any great degree of certainty be sure exactly what sort of savings rate will deliver a meaningful income replacement level in retirement.

Recall the fundamental pension equation that underlies any retirement system:

Contributions + Investment returns = Benefits

This applies to both defined benefit (DB) and defined contribution (DC). In both systems, investment returns are uncertain. The difference between the two lies in which of the other two components of the equation is held constant. In DB the benefits are defined, so contributions are uncertain and depend on variations in investment returns. In DC it's the other way around; the contributions ...