Consider this: A young woman enters the workforce at age 25 and is automatically enrolled in a defined contribution (DC) plan at 3% of pay. The plan automatically escalates her deferral by 1% until the woman is deferring 10% of pay annually. When you add to this a safe harbor match and give the participant 7% per year returns, she theoretically retires by age 60 a wealthy woman.
Sounds great, right? However, as John Lowell, partner and retirement actuary with October Three, who is based in Atlanta, notes, this is rarely reality. What if the woman gets married and has children and stops work to take care of the children? Or, what if the woman has a period of time where paying for child care costs, a mortgage or health care urges her to reduce her deferrals or to take a loan from her DC plan? What if she involuntarily loses her job? In addition, Lowell says DC plan participants should understand that 7% per year returns is not a reality.
This is the problem with retirement savings models, says Drew Carrington, head of Franklin Templeton Investments’ U.S. large market institutional defined contribution (DC) business, who is based in San Mateo, California. “It is also partly a more generalized problem in the [retirement] industry to oversimplify the retirement challenge,” he tells PLANSPONSOR.
Almost all of these assumptions are wrong, he says. People change jobs every five or so years; many new hires will not be fresh out of college and have probably saved somewhere else. Models simplify decisions about retirement, including when a person will retire and when they will claim Social Security. “These are usually household decisions, but models are for individuals,” he notes.
Lowell adds that every time you throw market volatility in the mix, even if it has a mathematical average equal to the assumption, it will bring the outcome down. As a simple example, Lowell says, if the woman in the example has a zero return in year one, then a 14% return in year two, the cumulative return is not 7% compounded, it’s less. NEXT: Adjusting for reality