The Challenge of Retirement

By Dr. Sabuhi Sardarli - Associate Professor of Finance, Phillips 66 Faculty Fellow

An average retiree is not prepared for the financial impact of giving up on their current income. This retirement insecurity partially explains the steady increase in the labor force participation rate of individuals over 65.[1] The problem is with the readiness and the health of three primary sources of post-retirement income. It is past time to address these problems more proactively. In this policy piece, I argue for making necessary regulatory changes to enable better investment guidance for retirement planners.

The first source for retirement income is the government program funded by payroll taxes and structured as pay-as-you-go manner. The program has long-term financing shortfalls, primarily because of aging population resulting in lower receipts and higher benefit payouts. The Old-Age and Survivors Insurance (OASI) Trust Fund, the entity tasked with managing Social Security system recently reported that trust’s reserves will be depleted by year 2034, resulting in an inability to pay out full benefits. Instead, the continuing tax income will be enough to pay about 76 percent of expected amounts to the beneficiaries.[2] To make matters worse, the recent COVID-19 pandemic is expected to make these projections even grimmer as the unemployment levels have spiked, resulting in lower payroll taxes collected. Additionally, there are concerns that older employees who have recently lost their jobs may not rejoin the labor force and will simply wait to draw from the Social Security given they were close to the cutoff age.[3]

The second source of retirement savings consists of individual retirement accounts (IRA), personal savings, home equity, etc. IRA’s are tax-deferred investment tools where individuals can save funds during employment and draw down post retirement. However, only about 36 percent of US households older than age 65 even own any type of individual retirement account. Median IRA balance for the 60-64 age group is about $40,000.[4] Regarding personal savings, the rate at which savings are put away have fluctuated in the 3% to 7% range during the last few decades, a significantly lower number compared to many of the OECD countries (relatively wealthier group of developed and emerging economies).[5] Median savings balance for individuals over 65 is around $15,000.[6] In the meantime, median value of household debt for the head of household close to the retirement age (55-64) has steadily increased in the last three decades closer to $60,000. Out-of-pocket health care costs have also increased in that time frame.[7]

That brings us to the third source: employer-sponsored defined benefit or defined contributions plans. Given that defined benefit plans are fast disappearing, let’s focus on the defined contributions plans such as 401(k)’s. The percentage of retirement investors in their 60s with more than $100,000 in their 401(k)’s is around 50 percent assuming a 30-year tenure.[8] Is $100,000 is enough for a comfortable retirement? Assuming median annual income level of about $48,000 (according to BLS) and the retiree who needs about half of that median pre-retirement income during post-retirement (commonly referred as salary replacement rate), $100,000 will not even last five years. If the salary replacement rate is 80 percent, the funds will last less than 3 years.[9] If an average 25-year old started a 401(k) plan back in 1984 and contributed regularly, they would have accumulated over $350,000 by 2019, an indication of a significant shortfall when compared to the above statistics. Moreover, the median defined contribution plan balance for the second- and third-income quartile is about $28,000 and $61,000, respectively. It is safe to say that an average retiree is not financially prepared for the consequences of their retirement and a large component of this under-preparedness falls on the performance within 401(k) plans.

The current situation is the result of gradual changes to employee sponsored retirement savings system. Defined benefit plans used to be the primary vehicle used by both public and private sector employers. In these plans employer funds and guarantees post-retirement pension benefits. Over the last 40 years, there has been a significant shift away from these plans towards defined contribution plans, such as those provided under section 401(k) of the U.S. Internal Revenue Code. In these plans, instead of guaranteeing pension benefit, employer voluntarily provides funds today to be contributed toward the employee’s retirement where investment choices are made available with the help of third-party plan administrators. These administrators are contracted by the employer (also called plan sponsors) to design the plans and manage the daily activities such as allocating employer contributions, processing plan documents and benefit statements, processing distributions, ensuring plan compliance and disclosure with regulatory agencies such as the Department of Labor and the Internal Revenue Service. While some third-party administrators provide their own investment funds within the plans they administer, others are specialized in the administration aspect only and contract with additional third-party financial institutions to provide the investment funds. Typically, there are 18-20 investment choices that include mutual funds with equity, debt, or balanced focus; target-date funds that change composition as the target retirement date approaches; company stock that represents equity stake in the employer; and safer assets such as money market funds, stable value funds, or annuities. The key feature of these plans is that the investment decisions are left to the employees.

There are several reasons for this shift away from the defined benefit plans. First, defined contribution plans give a better control to employers of their pension costs. If the pension trust performance is lower than expected additional employer contributions are required to provide the promised benefits. In contrast, with defined contribution plans, an employer may or may not choose to contribute to the individual retirement accounts. Even if an employer chooses to provide funds, the uncertainty of these payments is significantly lower when compared to defined benefit plans. In contrast, underfunded defined benefit plans can be a drag on firm’s performance and liabilities. Second, some have linked the decline of defined benefit plans to the loss of collective bargaining powers as labor unions have experienced similar declines in the same time frame. Third, the regulatory burden on the administration of defined benefit plans has increased more than that on the defined contribution plans, perhaps causing firms to shift. Finally, the demand side explanation is that the defined contribution plans allows for more workforce mobility as defined benefit pension plan vesting is highly dependent on the length of employee’s tenure.

No matter the economic rationale of this shift, one point is crystal clear. The bulk of the risk associated with retirement planning has shifted from employer to employees. Some of the risks that are re-distributed are: investment risk (choice of investments and the subsequent return performance), inflation risk (rising cost of living and eating into the purchasing power of the savings), longevity risk (risk of outliving the retirement funds), and market timing risk (market crash risk close to retirement date). Unfortunately, an average employee is not equipped to bear these risks and the result is the underprepared retirement. The ultimate success of a defined contribution retirement plan performance depends on two complex steps. In the first step, plan sponsors (employers) and third-party administrators must design a plan that offers good quality, lower cost investment choices and lower administrative cost plans that allows to create well-diversified portfolios at a relatively low cost. They also should monitor the plan menu and modify it continuously. The second step involves employees making educated choices within the plan which requires financial literacy, consisting of understanding of investments, risk and return dynamics, portfolio diversification, etc.

The academic finance literature is rich in showing that both steps are fraught with problems. For example, third-party administrators are more likely to use their own poorly performing funds in the 401(k) plans that they manage, likely due to their realization that the plan participants are captured consumers.[10] Similarly, my joint research with colleagues indicate that funds that are owned by plan administrators have higher fees and lower performance, especially when the administrator is an asset management firm, a commercial bank, or an insurance company.[11] Administrative fees are another layer of costs on top of each individual investment fee (which typically include expense ratios, management fees, 12b-1 marketing fees, etc.) are also important to the plan performance. These administrative fees are typically less well-understood, and we find that for certain types of administrators, these fees can be significant.[12]

However, even when a plan is well-designed, the second step that falls on the shoulders of the employees can be a daunting task. Important decisions, include determining the amount of contributions, deciding how to pick from the plan menu, making rebalancing decisions, and understanding the implications of taking out loans against the plan assets or changing employers, which typically leads to leakages from the plan. Most employees are overwhelmed by these decisions. There is ample research that document significant issues such as low participation rates, investment biases, inertia, lack of rebalancing, issues with framing, and lack of financial literacy.[13] In a recent study, my colleagues and I uncover that plan participants even rely on crude heuristics such as picking funds that are simply listed at the top of the plan menu, despite the fact that investment choices are typically listed in an alphabetical order.[14] Perhaps, an even more depressing fact is that push for widespread financial education has not resulted in tangible effects.[15] This phenomenon maybe explained by the propensity of typical employees to do nothing and follow the path of least resistance.[16]

It is time to create mechanisms that allow and encourage plan sponsors and administrators to provide better guidance for plan participants. As it stands, plan administrators are not required and are very reluctant to provide any investment advice due to the fear of litigation in case the plan performance falls short of the investor’s expectations. Therefore, most administrators provide simple disclosures of fund’s historical performance, as well as participant rights and obligations under a plan, typically when an employee is first hired. Subsequently, quarterly performance statements are provided without any help or advice. Although employers can provide access to advisors, only a minority of them provide this service as most 401(k) plan attorneys council their clients against this access due to the potential liability risk.[17]

The mechanism I propose needs to relieve the plan sponsors and administrators from litigation risk if the presented information follows pre-determined guidelines. For example, it is well-documented that fund expense ratio (fund level investment cost) is a more reliable predictor of future return performance than past performance, with expense ratio and performance being negatively correlated.[18] The plan administrators can nudge the investors toward low cost options with either highlighting them separately or by listing investment options in the ascending expense ratio order. Alternatively, low volatility funds could be placed at the top of the plan menu given significant evidence in the literature that low volatility portfolios

have outperformed higher volatility portfolios over the past several decades.[19] Another suggestion would be requiring plan administrators to provide risk-adjusted performance metrics net of fees (such as CAPM or multi-factor model alpha), especially for actively-managed funds, because most active managers fail to create alphas after accounting for the investment fees. Finally, a suggestion of simple optimization techniques that use risk-return characteristics of the plan options would allow to simplify the choice for the investors.

What I propose is in the spirit of the changes that have been previously enacted by the Department of Labor (DOL), the arm of the executive branch overseeing defined contribution plan administration. In 2010, DOL released rules requiring more transparency of fees and expenses of these plans. Similarly, in 2012, DOL imposed new disclosure requirements of indirect fees that were linked to revenue sharing agreements between plan administrators and investment fund providers. These changes were necessary as it is was known that these direct and indirect fees significantly affect the ultimate plan performance. Perhaps more importantly, with the passage of the Pension Protection Act in 2006, DOL created a regulatory safe harbor rules in 2007 to allow for automatic plan enrollment, while giving legal protection to plan sponsors and administrators as long as the default investment choices followed certain diversification rules. This action was necessary as we learned that plan participation rates were significantly lower than desired as employers had to opt-in. Armed with the goal of increasing participation and the knowledge of individual biases, DOL gave legal protections to create an opt-out scheme instead. However, although this action resulted in significant increase in participation rates, the default investment options such as target-date funds have their own issues such as higher investment costs, short-fall risk, and glide-path adjustment risk.[20]

It is time to consider actions that allow assistance to employees that do not want to rely on default investment options but are also overwhelmed with investment decisions with their retirement plan. They will not receive any advice from their plan sponsors or administrators as long as a legal protection similar to the 2007 DOL Safe Harbor rule is not extended. The details of the specific guidelines can be debated but there is plenty of evidence in the finance literature for that debate to start.


[1] US Bureau of Labor Statistics Current Population Survey -
[2] Old-Age and Survivors Insurance (OASI) Trust Fund Summary of the 2020 Annual Report -
[3] Carlson, Bob. “The Pandemic Reduces Social Security’s Solvency”. Forbes Magazine, April 2020 -
[4] Employee Benefit Research Institute, “EBRI IRA Database: IRA Balances, Contributions, Rollovers, Withdrawals, and Asset Allocation, 2016 Update”, April 2018 -
[5] OECD Data on Saving Rates -
[6] 2016 Federal Reserve Survey of Consumer Finances -
[7] Center for Medicare and Medicaid Services and US Bureau of Labor Statistics
[8] Employee Benefit Research Institute, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2016”, September 2018 -
[9] US Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey -
[10] Pool, Sialm, and Stefanescu, 2016. "It Pays to Set the Menu: Mutual Fund Investment Options in 401(k) Plans," Journal of Finance, Vol. 71(4), 1779-1812.
[11] Doellman and Sardarli, 2016. “Investment Fees, Ne Returns, and Conflict of Interest in 401(k) Plans”, Journal of Financial Research, Vol 39 (1), 5-33.
[12] Doellman and Sardarli, 2016. “Investigation of Administrative Fees in Defined Contribution Plans”, Financial Analysts Journal, Vol 72 (2), 41-51.
[13] Some examples of this literature include Agnew, Balduzzi and Sunden (2003), Benartzi and Thaler (2001, 2007), Duflo and Saez (2002), Finke, Howe and Huston (2017), Huberman and Jiang (2006), Lusardi and Mitchell (2007), and Madrian and Shea (2001).
[14] Doellman, Itzkowitz, Itzkowitz, and Sardarli, 2019. “Alphabeticity Bias in 401(k) Investing”, Financial Review, Vol 54 (4), 643-677.
[15] Fernandes, D., Lynch, J.G., Netemeyer, R. G., 2014. Financial literacy, financial education, and downstream financial behaviors. Management Science 60(8):1861-1883
[16] Choi, J., Laibson, D., Madrian, B., Metrick, A., 2002. Defined Contribution Pensions: Plan Rules, Participant Choices, and the Path of Least Resistance. Tax Policy and the Economy 16, 67- 113.; Carroll, G.D., Choi, J.J., Laibson, D., Madrian, B.C. and Metrick, A., 2009. Optimal defaults and active decisions. The Quarterly Journal of Economics, 124(4), 1639-1674.
[17] Government of Accountability Office, 2016. “401(k) plans: DOL Could Take Steps to Improve Retirement Income Options for Plan Participants”.
[18] Elton E, Gruber M, Blake C, 1996. The persistence of risk-adjusted mutual fund performance, Journal of Business, 69:133-157; Carhart M., 1997, On persistence in mutual fund performance, Journal of Finance 52, 57-82.
[19] Baker, M., B. Bradley, and J. Wurgler, 2011, Benchmarks as limits to arbitrage: understanding the low-volatility anamoly, Financial Analysts Journal 67 (1), 40-54.; Karceski, J., 2012, Returns-chasing behavior, mutual funds, and beta’s death, Journal of Financial and Quantitative Analysis, 37 (4), 559-594.
[20] Issues with target-date funds are documented in Spitzer, J., Singh, S., 2008. Shortfall risk of target-date funds during retirement, Financial Services Review 17, 143-153; Scott, J., Sharpe, W., Watson, J., 2009. The 4% rule – At what price? Journal of Investment Management 7(3), 31–48; and Elton, E., Gruber, M., De Souza, A., Blake, C., 2015, Target date funds: Characteristics and performance, Review of Asset Pricing Studies 5(2), 254-272.



About the Author

Dr. Sabuhi Sardarli

Associate Professor of Finance
Phillips 66 Faculty Fellow