The stock market has had an extraordinary rally over the past five years: the S&P 500, including dividends, is up 104% on a cumulative basis — 15% annualized, as of Nov. 21. Yet this rally has lacked the “irrational exuberance” of past rallies.
Despite some post-election optimism, we remain in an environment characterized by low growth, low inflation and ultimately, low expected returns. Importantly, interest rates have come down globally to near or below zero.
Low interest rates hurt individual investors in two ways: they translate into lower expected returns in the accumulation phase, and they make it harder to generate income in retirement. Consequently, no matter where we look around the world, there is a growing gap between the level of wealth investors want or need to retire (their “number”), and what they can reasonably expect to accumulate (their outcome).
People like to think of their “number” in terms of a dollar amount, but the size of your “pot” at retirement might translate into very different retirement income levels if interest rates are high or low. In the report “Pensions at a Glance, 2015” the Organization for Economic Co-operation and Development estimated income replacement rates across countries. For each country, they calculated how much of the average employee's lifetime average salary can be replaced by purchasing an annuity at retirement assuming 2% real interest rates, a generous assumption given current levels. For example, average income replacement is 28% in the United Kingdom, 40% in Japan, and the United States is not much better at 45%. If we assume that most people would be happy to retire with a 75% income replacement ratio, the gap is quite wide.
However, the data include only mandatory pensions, for example, Social Security in the United States. Individuals may also have access to accumulated wealth in the value of their homes, defined benefit plans or defined contribution plans. For DC plan sponsors, the question remains: After accounting for other sources of retirement income, can DC plans bridge the gap?
Low expected returns are not the only challenge. Society's problem with underfunded pensions is expected to grow as life-expectancy of the population continues to extend. In the United States, the OECD shows that the percentage of the population 65 years and older has grown to 15% in 2014 from 10% in 1974. Australia, Canada, Germany, Japan, and the U.K. all show significant increases as well. In Japan, the number of people 65 and older has grown to more than 25% from 8% during that period.
To be fair, the size of retirement systems globally has increased significantly as well. According to Willis Towers Watson PLC's 2016 global pension assets study, from 2005 to 2015, global pension assets have grown to $35 trillion from $21 trillion — a 5% annualized growth rate. Are these assets being invested to bridge the gap?