Summary
Defined-contribution plans can enable individuals to accumulate tax-deferred savings that far exceed their expectations. On retirement, however, they may be shocked to discover how a seemingly ample savings amount translates into only a modest level of sustainable annual income on an after-tax, after-inflation basis.

Individual Responsibility for Retirement
Individuals in the United States — and indeed throughout the world — are finding that they must take more responsibility for providing for their own retirement needs. These needs can be quite challenging, raising a number of issues that could well reach the level of societal concern: inadequate savings rates, inefficiencies in investment, costly annuitizations, excessive administration costs, inability to sustain appropriate investment policies, integration with health and other life contingencies, and so on. Many of these issues are already the subject of widespread discussion (if not resolution). However, there is one substantial problem that has not been given the attention it deserves: the cognitive dissonance that keeps many individuals, even those who are relatively knowledgeable, from recognizing how a large savings accumulation can translate into a relatively modest annual flow of payments. This “annuity shock” can actually be exacerbated by the success of tax-deferred accounts, such as 401(k) plans and IRAs.

Defined-contribution (DC), tax-deferred savings plans are superb vehicles for accumulating savings. With reasonably good fortune, individuals can accumulate sums through DC plans that far exceed any “outside” savings accounts or the net equity in their home. For many, this tax-deferred accumulation may represent a level of wealth that surpasses their expectations. Indeed, it is all too easy to feel so well off that any retirement needs can be viewed as easily accommodated. Investors who are lulled into such complacency may be surprised to discover just how much savings are needed to provide a sustainable annual income — after tax and after inflation!

Annuity Factors
The annuity factors in Exhibits 1–3 are the payment levels as a percentage of savings that can be sustained 10, 20, or 30 years on an after-tax, after-inflation basis. These factors illustrate the deleterious impact of taxes and inflation for level annuities with income tax rates of 0 percent, 20 percent, and 40 percent and a range of different earnings, inflation, and real rates. The simplifying assumption here is that all earnings are subject to a single tax rate (i.e., eliminating consideration of tax-exempt bonds or capital gains–generating investments).

As a baseline example, consider postretirement investments having a 6 percent nominal earnings rate subject to 20 percent taxes and 3 percent inflation. The objective is to determine a first-year payment that will rise with inflation and be sustained for 20 years after incorporating all tax liabilities. From the “6/3/3” line in Exhibit 2, these first-year factors are 5.32 percent for the tax-deferred plan and 5.97 percent for a taxable account. A $300,000 accumulation would thus be able to fund an after-tax, after-inflation 20-year annuity of only $16,000 from a tax-deferred account and $18,000 from a taxable account.

Many individuals would indeed be shocked to learn that what they might consider a rather princely sum could generate such modest levels of sustainable annual income.

Single Annuity Estimate for Total Savings
Another source of surprise is that it does not matter a great deal, under these conditions, whether the $300,000 is lodged within a tax-deferred account or in a taxable savings account lying outside any tax shelter.

The baseline situation with a 20 percent tax rate, a 6 percent nominal earnings rate, and 3 percent inflation results in only a modest difference in the annuity factors for the two account types. The similarity of the taxable and tax-deferred annuity factors can greatly simplify “first-cut” retirement calculations. Because the two factors are so close to each other, a single midvalue factor could be applied to both types of funds. For a 20-year annuity, this common factor would be 5.65 percent, whereas for a 30-year annuity, the factor would be 4.19 percent. These factors can then be applied to the total dollar amount of funds saved — regardless of whether they are located within a taxable or tax-deferred framework. This simplification can help individuals see quickly where they really stand in relation to their retirement needs.

It should be emphasized that, although tax-deferred and taxable savings face roughly similar annuity factors, a properly designed tax-deferred savings plan can play an enormously important role in building savings to significant levels, especially if the plan provides for consistent contributions, ample matches, a reasonably decent investment process, and importantly, appropriately low costs.

It is worth trying to understand why these factors are so much lower than many would expect. In the taxable account, the 6 percent interest rate — including the 3 percent inflation component — is first subject to a tax payment of 20 percent that reduces the after-tax earnings rate to 4.8 percent. The insidious “tax” from inflation then strikes a second time to take away another 3 percent each period, reducing the nominal 6 percent to a net rate of 1.8 percent. Consequently, the bulk of the payments will really be derived from the original principal rather than from any large amount of earnings.

In the case of the tax-deferred account, the savings can be compounded on a tax-free basis at the original 6 percent rate. Each payment, however, is subject to the twin effects of year-by-year inflation together with a tax on every dollar of payment. Within the tax-deferred shelter, inflation reduces the effective accumulation rate to the real rate. For example, Exhibits 1–3 show that when the real rate is 3 percent, the same tax-deferred factor applies whether the inflation rate is 3 percent or 5 percent. Given the baseline situation, the key earnings rate for a tax-deferred account will always be just the assumed 3 percent real rate of interest. The taxes applied to every payment will then reduce the effective earnings rate further, bringing it closely in line with the effective rate of 1.8 percent derived earlier for the taxable account. It is this convergence of effective rates, under our baseline assumptions, that leads to the taxable and tax-deferred accounts having virtually the same net annuity factors.

Toxic Combination of Taxes and Inflation
The dissonance between the perception of an ample savings amount and a modest annuity factor is caused largely by this toxic combination of taxes and inflation over long periods. Even low levels of inflation can have a devastating impact over the periods relevant for retirement.

Every DC plan is a “mini” defined-benefit (DB) plan with the liabilities determined by the household’s expected lifestyle in retirement. In the United States, corporate DB plans tend to promise nominal payments in retirement, perhaps with some form of optional ad hoc inflation adjustments. However, an individual’s liabilities are based on their real needs after deducting the relevant inflation components. In retirement, some of these inflation components — for example, spending for healthcare — may well exceed the general headline rate of inflation. In Canada and in Europe, the standard DB retirement plans have historically incorporated adjustments for inflation as the general rule. However, full inflation indexing can be extremely costly. In recent years, to control these inflation-related costs, several European plans with significant surpluses (as typically defined) have been amended in various ways, for example, making the inflation indexing contingent on adequate investment performance. These visible cost-control moves by well-funded DB plans underscore the “real” burden that inflation places on retirement plans.

Higher Taxes and Inflation Rates
The preceding discussion focused on an effective tax rate of 20 percent. Higher tax rates erode the net payments and consequently lead to lower annuity factors. Higher tax rates would also lead to a wider differentiation between taxable and the tax-deferred accounts, with higher taxes having the more deleterious impact on the tax-deferred account. As an example, consider the baseline case in Exhibit 3 with an assumption of 3 percent inflation and 6 percent earnings but now in a 40 percent tax regime. The 20-year taxable account factor drops to 5.33 percent (down from 5.97 percent with a 20 percent tax rate), while the tax-deferred account factor declines to 3.99 percent (from 5.32 percent).

The impact of higher inflation is largely dependent on the relationship of the nominal earnings to the real rate. With the real rate kept constant at 3 percent, a higher, 5 percent inflation would take the earnings rate to 8 percent. As noted earlier, the tax-deferred factors are determined by the real rate. Consequently, with the real rate fixed at 3 percent, the tax-deferred 20-year annuity factor remains at 5.32 percent for the baseline 20 percent tax rate. Under the same conditions, however, the taxable account factor drops slightly from 5.97 percent to 5.76 percent (see the 8/5/3 line in Exhibit 2).

In contrast, if the nominal earnings were somehow kept constant at 6 percent, then the higher, 5 percent inflation would imply a real rate decline to 1 percent. As might be expected, this (happily rare) circumstance would severely affect both the deferred and the taxable accounts, bringing their respective factors down to 4.41 percent and 4.92 percent, respectively (see the 6/5/1 line in Exhibit 2).

Incorporating DB Payments
Although the tone of the preceding comments may have been rather grim, there is some good news in these annuity factors. Suppose an individual also receives a stream of annual nominal or inflation-indexed payments from a corporation or some government entity. Just as an accumulation translates into smaller-than-expected annual payments, so a DB stream looms larger in present-value terms. For example, a 30-year stream of fully indexed payments that starts at $15,000 would be equivalent, under the baseline assumptions, to a tax-deferred accumulation of $370,000. The size of this implicit sum might be a pleasant surprise, but most recipients would, for good reason, still focus on its modest size as an annuity payment.

Conclusion
As noted at the outset, DC plans can enable individuals to accumulate far larger sums of money during their working years than would otherwise be possible. Unfortunately, DC plans are also subject to a number of serious problems. We have focused here on only the narrow issue of how taxes and inflation can lead to a misperception of what constitutes an ample level of savings. Other problems include the difficulty of sustaining the appropriate risk posture, the limited availability of investment vehicles, administrative and transaction costs, annuity costs, the lack of socialized mortality risk, life contingencies that call for premature drawdowns, the simple inability of many households to take full advantage of the tax deferral or matching programs, and perhaps even more devastating at the outset, the inability of a DC savings plan to be consistently maintained in a globalized world characterized by high job turnover.

The movement of DB plans to DC plans can certainly reduce the cost and the risks for the pension fund sponsors, but the problems thrust upon the DC participant become apparent only when it is too late. These problems are both serious and likely to represent a heavy societal burden in the years to come.

Martin L. Leibowitz is a managing director at Morgan Stanley, New York City. Anthony Bova, CFA, is an associate at Morgan Stanley, New York City.

Source: Morgan Stanley Research.

Source: Morgan Stanley Research.