Sunday, September 23, 2012

Our Broken Retirement System

The magnitude of the retirement problem America currently faces is difficult to comprehend.

Our retirement system is based on the assumption that the average Joe can save and successfully invest enough of his family's lifetime income in 401(k) and other retirement savings accounts to, with the help of Social Security benefits, maintain his standard of living after he retires. That requires accumulating at least hundreds of thousands of dollars of wealth in retirement accounts by roughly age 66, and perhaps a few million if your household income before retirement is six figures.

In the thirty years since the advent of the 401(k) plan and the beginning of the end of pension systems, few American households have been able to accumulate anywhere near those amounts.
The median value of a 401(k) account for someone approaching retirement age was recently $78,000.

Not millions. Not hundreds of thousands. $78,000.

Half of the retirees in the study — nearly 30 million American households— had no retirement savings at all. A lot of American households will simply drop out of the middle class when they retire.

Teresa Ghilarducci put it this way in a New York Times opinion piece entitled, "Our Ridiculous Approach to Retirement":

"The specter of downward mobility in retirement is a looming reality for both middle- and higher-income workers. Almost half of middle-class workers, 49 percent, will be poor or near poor in retirement, living on a food budget of about $5 a day."

Most Americans ages 50 to 64, 58 million of them in 2010, probably won’t have enough retirement assets to maintain their standard of living when they reach their mid-sixties, according to a 2012 study by the Schwartz Center for Economic Policy Analysis.

401(k) plans haven’t worked very well. Conservative talking heads love to say, "Boomers didn't save enough",  but it isn’t just Baby Boomers; Gen-Xers are even worse off based on their current 401(k) account balances. No generation has ever been asked to accumulate this much wealth and there is little reason to believe future generations will do better unless the system changes.

Will yours be one of the lucky households whose standard of living won't decline in retirement?

According to author and investment adviser, William J. Bernstein, you need to save 20 to 25 times your residual living expenses — that is, the yearly shortfall you have to make up after Social Security benefits and any pensions you might receive.

In it's simplest scenario, if you need $50,000 a year to maintain your current standard of living in retirement and Social Security benefits will cover $20,000 per year, your shortfall is $30,000. If that $30,000 is to come from your savings, you need 20 to 25 times that amount, or somewhere between $600,000 and $750,000 saved by the time you retire. If you don’t have enough personal savings to close that gap, your standard of living is going to decline, perhaps dramatically, once you retire.

The typical middle class American family approaching retirement has been able to save less than a quarter of what it needs to retire on, according to a study by the Center for Retirement Research at Boston College and reported in the Wall Street Journal in February 2011. That leaves most families highly dependent upon Social Security retirement benefits, which are meant to replace at most 30% of what you were earning before you retired.

For households that earn more, it will replace a smaller percentage. And that's at full retirement age, which is 66 for most people about to retire. Claim benefits at age 62 and they will replace perhaps 25%. So, figure on Social Security benefits replacing between a third and a fourth of your pre-retirement income.

What will it be like to live entirely off Social Security benefits? An article by Paul Sullivan in the New York Times in 2012 painted a picture. It isn’t pretty, but it’s what several tens of millions of Americans are facing.

Most people collecting Social Security benefits today have little or no other income.

Data collected by the Social Security Administration (SSA) from 2001 found that Social Security benefits provided more than half of the total income for almost two-thirds of retirement-aged households and provided at least 90% of income for a third of this group. That’s a lot of dependence on a benefit that is only meant to keep families off welfare.

The maximum annual Social Security workers benefit in 2012 is about $39,600 per spouse, but receiving a benefit that large would require that you paid the maximum in FICA taxes throughout your career (i.e., earned a lot of money) and that you delayed receiving Social Security benefits until age 70, when they max out. The average benefit is only $14,760 per individual per year.

So, the question you’re probably asking about now is, “How much money will I be able to spend when I retire?” For most households, the answer will depend on how large your (and your spouse’s) Social Security benefits will be and how much you have saved for retirement.

To answer the first question, go to the SSA’s website at and get an estimate of your retirement benefits and your spouse’s, if you are married.

The second question, “how much can I spend each year from my retirement savings?”, is a little more difficult. The answer will depend on how you choose to invest your retirement savings, but a ballpark estimate is 4.5% of your portfolio value on the day you retire. For example, if your retirement savings total $100,000 on the day you retire, you can spend about $4,500 from your savings annually and you can increase that amount by the rate of inflation each year. (Do not include home equity in your savings estimate.)

Here’s an example. Assume the SSA website estimates that you will receive $14,000 a year in workers benefits and your spouse is entitled to $7,000 a year in spousal benefits. The two of you have $100,000 saved in a 401(k) account. Your household will receive $21,000 a year in Social Security benefits and can spend $4,500 from savings. You can spend a total of $25,500 a year after you retire.

This is an estimate. There are steps you can take to increase your retirement income and mistakes you can make to decrease it. I will discuss those in future blog entries, and I cover them in my book, Retiring When Your 401(k) Fails.

(For a more detailed explanation of calculating the shortfall, see my post entitled, "Closing the Shortfall — How Much to Save for Retirement.")

Unless your pre-retirement earnings were relatively low, you probably need at least a quarter million dollars in retirement savings to avoid a decline in your standard of living after retirement. If a quarter million bucks sounds like a lot to save, keep in mind that it will only support about $11,250 of retirement spending per year (4.5%). Savings of $78,000 will support spending of about $3,510 a year.

Don’t be surprised if the income you calculate for your household in retirement is disturbingly low. For most households it will be. As I said at the beginning, most households haven’t been able to save nearly enough for retirement and Social Security benefits don’t go very far.

If you have saved enough, then give yourself a pat on the back. You succeeded where the vast majority of Americans have failed. If you failed, you have lots of company and winning this game is always a long-shot.

The American retirement system doesn’t work, except for the very lucky and the very wealthy, as a lot of households are about discover over the next few decades. I can't fix the U.S. retirement system, but I can help you make the best of a challenging situation. Please drop by my blog frequently for more information. (Oh, and did I mention my book, Retiring When Your 401(k) Fails?)

In future blogs, I’ll discuss some of the things you might do to improve your financial situation in retirement.

Don’t expect miracles, though. There are no easy answers.

1 comment:

  1. If, as a couple, you need 50,000 dollars a year to cover expenses - you must be earning about 66K/yr. You need to spend 16K in taxes (FICA, Fed, state, local).
    If you make 66K in income - reasonably split between husband and wife) your SS benefits would be nearer to 33K.
    Still a clear shortfall but not near as dramatic as your example. That 17K shortfall would require savings of 425K.
    Now. consider that the couple actually saves with the intent of securing a retirement. The first thing that happens is they have to learn to live on less than 50K (some must go into savings). And of course the retirement savings grows.
    If they put 5% of their salaries into a traditional IRA their available spending would drop to about 47K. Their shortfall in retirement is then only 15K. And their savings (assuming 3% above inflation) would hit about 200K.
    You can continue this game to find that a savings rate of 8.2% would leave the couple with 46K/yr. to spend and nest egg after 35 years of 330K. Their shortfall (now only 14K) would be entirely covered by their retirement savings.

    Saving 330K may be difficult, but not nearly as bad as having to save 700K. I do believe that promulgating these unrealistic high numbers is self-defeating. Many people hear these goals and think "No Way". So they give up and don't save anything.