The savings shortfall

Numerous studies have predicted a large retirement ‘savings gap’ — the shortfall in current or projected pension provisioning from a benchmark level of retirement income. The figure of 70% of pre-retirement income has become the heuristic benchmark, often termed a 70% ‘replacement rate’. Though sometimes criticised for arbitrariness, it is actually supported by the economic and social science literature since the 1960s (Modigliani 1966).

Of course, the definition of pre-retirement income is also contentious (such as the lifetime average or the average in the 10 years before retirement). And some experts prefer a range of replacement rates. The UK Pensions Commission, for example, uses an 80% threshold for those earning the least during their working lives, falling to 50% for the highest earning quintile. 

The choice of benchmark can result in significant differences. Add in other variables and the permutations are innumerable. But no matter what assumptions are made, researchers always find a gap — both in the UK and across advanced economies as a whole. In other words, saving needs to increase, pensioner spending decrease, or working lives lengthen.

Work more, save more, buy less stuff

As our Millennial Matters publications are concerned primarily with younger generations and the impact they are having, research from the International Longevity Centre (ILC) provides the most pertinent delineation of the savings gap. Their researchers calculate the annual savings that someone needs to make in order to generate a 70% replacement rate if they entered the workforce today at the average age of entry. Across advanced economies, if today’s savings habits continue, there is a shortfall equivalent to 5% of pre-retirement earnings. In other words, workers need to save an additional $2,015 a year. In the UK, the gap is a little lower at 4% (Franklin & Hochlaf 2017). 

Having a saving pattern that falls short of benchmarks is not an especially millennial affliction. Generation X is also way off track. Indeed, in the UK, they are likely to be worse off than millennials because many have gone without the defined benefit pensions enjoyed by their parents, but started work well before enrolment in defined contribution schemes became automatic (Intergenerational Commission 2018). 

A report commissioned by the World Economic Forum (WEF) focused on all current workers, not just new entrants, in eight major economies. They found that savings fall short of a 70% replacement rate by a total of $67 trillion, or 150% of combined GDP. That’s 6% of GDP per year during the time the median worker has left to retirement (Berenberg 2018). Clearly this isn’t just a millennial matter. 

The ‘intergenerational savings gap’, which is the additional savings that a new worker would need to make to match incomes of current pensioners, is even bigger: 12.6% of earnings, or $5,080 a year. Again the UK is lower, at 6%, or around $3,000. European countries fare worst on this basis, due to reforms that have reduced the generosity of state pensions. 

To put it another way, the average new worker in the UK, the US, Canada or Germany needs to save, in total, between 10% and 20% of their income to meet a 70% replacement rate, and between 15% and 25% of their income to match the retirement incomes of previous generations (figure 1, Franklin & Hochlaf 2017). Today, the average savings rate across these economies is much lower at 4.5% (although the underlying data include non-working-age households too). According to a YouGov study, 30% of people aged 45 to 54 — in what should be their prime years of saving — save none of their disposable income (CEBR 2016).

The WEF projects that the savings gap in the eight major economies it studied will widen to over $400 trillion by 2050, from their current estimate of $67 trillion. In other words, saving will need to increase by 5%, or $9.4 trillion a year, just for the funding shortfall to stay where it is today. In the UK, $940 billion of extra saving is required to close the gap (WEF 2017). That’s 2.7 times current gross national saving every year for 35 years. Saving needs to start now.

Numerous studies that focus on just one country or just one source of retirement income reach similar conclusions: there’s a funding shortfall that’s likely to keep growing (cf. VanDerhei 2015; Munnell and Hou 2018).

We see three paths from here:

• work more: people retire later, the corollary of which may also be an increase in aggregate saving (see below).
• save more: saving increases today and consumption decreases.
• consume less: saving does not increase today, but consumption decreases tomorrow as workers start to retire on inadequate incomes.

The WEF report sums it up best: ‘Given the current long-term, low-growth environment, it is unrealistic to expect that saving ~5% of a paycheck each year of your working life will provide a comparable income in retirement.’ 

Figure 1: Intergenerational gap

^{How much an individual would need to save (% of income) to achieve the retirement income of previous generations.} 

_{^{Source: Datastream and Rathbones.}}

Don’t blame the young

Let’s get one thing straight: millennials are not frittering away their future pensions on heirloom avocados and turmeric lattes. In the UK, people aged 25 to 34 spend less relative to 55- to 64-year-olds than at any time since at least the 1960s. Adjusting for inflation, their consumption after housing costs is barely any higher today than it was in the late 1990s. This pattern reverses the increasing consumption of younger adults in the 1960s, 1970s and 1980s. In other words, it was the baby boomers who ate more prawn cocktails and drank more cappuccinos, extending consumption patterns both in their youth and in their golden years (Intergenerational Commission 2018). 

It may be that stereotyping has mistaken consuming more conspicuously for consuming more. There is survey evidence that millennials place more importance on having lots of money and expensive things than older generations (Ipsos Mori 2017). However, millennial avarice is not the reason why they may struggle to retire as comfortably as their parents.

Simply, millennials are paying more for the roofs over their heads, with pay packets that aren’t increasing by as much as previous generations’. In the UK, millennials at age 30 are earning less than Generation X did at the same age, in inflation adjusted terms. They are also less likely to be employed on the basis of a secure, full-time contract. Younger millennials are faring worse than older millennials. 

The stagnation in real pay since the financial crisis, the longest in 150 years, is making it harder for millennials to start saving more. 

Millennials are far from alone in their under-preparation. Generation X may be the most poorly positioned. Broader still, almost a third of US households were at risk of retiring with inadequate income in the 1980s. Today it’s 50% (Center for Retirement Research).