Sunday, October 28, 2012

Scary Things I Hear People Say about Paying for Retirement

Halloween seems like an appropriate time to talk about paying for retirement, because if the subject doesn’t scare the hell out of you, then you haven’t been paying attention.

More than half of American workers will leave the workforce with no retirement savings and will be forced to live on Social Security benefits alone. As Paul Sullivan described in the Washington Post, that isn’t a pretty prospect.

Even among the highest earners, very few have been able to accumulate enough retirement savings to maintain their standard of living after retirement.

Maybe we just say that last sentence in strange ways and that’s why it doesn’t seem to soak in. Let me try it again.

Almost everyone is going to have a lower standard of living after they retire. Almost everyone.

Pretty scary, right? Sometimes, though, the things people say about retirement are scary simply because they’re so out of touch with reality. Here are a few of the scariest.

I'm not worried. I’ll collect Social Security benefits.

If you have paid FICA taxes for more than 40 quarters or are married to someone who did, you will be eligible for Social Security retirement benefits, but they may not be as much as you expect. The average benefit paid in 2012 is about $15,000 a year, slightly more than you would earn from a minimum wage job in most states.

The portion of your pre-retirement income that will be replaced by Social Security varies by income level from about 69% for a household with $20,000 a year in income before retirement to about 36% for a household earning $90,000.  And, of course, the replacement percentage continues to grow for households earning more than $90,000 a year because the maximum Social Security benefit is about $36,000 per person.

The following table from an Aon Consulting study estimates the replacement percentages required.

You might think that households earning more than $90,000 a year would have plenty of retirement savings, but that isn’t the case. First, higher income earners have to replace much more of their pre-retirement income from their own personal savings because of the cap on maximum Social Security benefits. Second, statistics show that only about 5% of those high-earner households have saved enough to avoid a decline in their standard of living.

After Social Security benefits, the rest of your retirement income will probably have to be replaced by your 401(k) savings (the lighter blue stacks). The problem is that very few households, something on the order of 5% of them, have substantial personal savings to fill that light blue part of the gap.

So, yes, most Americans will collect Social Security retirement benefits, but without hundreds of thousands of dollars of retirement savings, the benefits may not keep you in the middle class.

Social Security won’t be around for me.

Conservative politicians have been trying to get rid of Social Security since it was created in the 1930’s and one day they may be successful. I personally don’t think they will be for two reasons. First, the Social Security shortfall isn’t really that hard to fix if you’re willing to adjust FICA taxes just a little.

Second, very few Americans have been able to save enough for retirement to stay out of the poor house even with Social Security. Maybe 5% of workers will be able to maintain their pre-retirement standard of living after retiring. Ending the program would generate a massive elderly poverty problem in this country and that is truly frightening.

I haven’t saved enough money. I’ll have to work longer.

Working longer is probably the most effective solution to the under-saving problem. It delays the day when you will need to start drawing down retirement savings, gives you a few years to add to those savings, and increases you Social Security benefit by delaying your claiming age.

But, here’s the catch: when you retire isn’t always your choice.  In a survey of recent retirees, more than half said they were forced to retire earlier than planned due to layoffs, age discrimination, health problems, the need to leave work to care for a family member and other reasons.

Working longer may be in your plans, but it may not be in your employer’s even if you and your spouse are still healthy enough to work.

I’ll claim Social Security benefits when I’m 62 because it takes ten years to break even if I delay claiming.

Basing your finances on when you believe you will die? Is that something you feel you can predict?

The problem with the break-even argument is that 1 in 4 Americans will live into their 90’s.  The ones that do will live decades with reduced Social Security benefits if they claimed early.

The goal of retirement planning should be to pay for your retirement if you live to be very old, not to make sure that you that you maximize benefits if you live less than your average life expectancy.

Look up “regret” in the dictionary and you’ll find a picture of a widow in her 80’s in poverty because she and her husband decided to claim Social Security benefits at age 62.

I’ll need to replace 70% of my income after I retire.

As the table above shows, most people will need to replace 78% to 94% of their pre-retirement income, depending on their income level.

Medicare will cover my health insurance needs.

Studies show that Medicare only replaces about 50% of all medical expenses. You’ll need to purchase a Medigap policy to cover the rest.

If you decide to retire before age 65, or are forced to, you may have trouble finding a private insurer that will cover you.

My average life expectancy is age 80. I need to plan for 15 years of retirement.

By definition, half of retirees will live less than their average life expectancy and half will live longer. If all retirees planned on living their life expectancy, half of them would die broke.

For retirement planning purposes, you need to plan on living a very long life, just in case you do. Think 95 or longer.

I’m too young to worry about it.

Some people like to say that “Boomers didn’t save enough”, but more than half (56 percent) of Gen X households are estimated to be at risk, according the National Retirement Risk Index (NRRI) developed by the Center for Retirement Research at Boston College. This compares with 41 percent of early Baby Boomers and 48 percent of late Boomers.

Nobody has saved enough. It isn’t clear that the typical middle class household is even capable of saving that much.

If you are 25 years old and plan to retire at age 65, you would need to invest about $390 a year and earn an 8% annual return to accumulate $100,000. Begin at age 35 and you would need to invest about $890 a year. Start at age 45 and you would need to invest $2,185 a year to accumulate $100,000.

As my favorite investment guru, William J. Bernstein says, “Save as much as you can, start as early as you can, and do not ever stop.”

Paying for retirement can be a frightening proposition, but ignoring it won’t make it go away.

Friday, October 12, 2012


Are you unwealthy?

Is that even a word?

No? Good, let’s make it one. I need a word that describes households that are firmly established in the middle class at present, but won’t have enough retirement savings to avoid a dramatic decline in their standard of living after they retire, possibly falling out of the middle class entirely.

The statistics clearly show that the wealthy can save money for retirement. They have plenty left over from their paychecks after paying the rent, putting food on the table and sending their kids to college. Here are the average savings rates by household income from a 2008 study by Aon Consulting:

The more you earn, the more you have left over to save for retirement in a tax-deferred 401(k). And, of course, the more money you make, the bigger tax break you get from the tax deferral. So, the wealthier you are, the more the government helps you save for retirement. No surprises there.

According to the chart above, households earning $20,000 save $396 a year on average for retirement, while a household with $90,000 of annual income saves $5,013 on average. Since the $20,000 household probably pays no federal income tax, there is no tax deferral to help with their saving. The higher-earning household gets to defer taxes on theirs.

But studies also show that the vast majority of the middle class don’t have adequate retirement savings.

The American retirement system, created in the early 1980’s and based on the concept of typical American households saving and investing in tax deferred accounts to complement Social Security benefits, has failed. About 83% of 401(k) balances hold less than $100,000 (Figure 1). Half of American workers have no retirement savings at all. (Click any chart to enlarge.)
Figure 1 ICI Research Perspective, VOL. 17, NO. 10, December 2011, p. 12.

About 59% of the accounts with balances over $100,000 belong to workers in their 50’s and 60’s (Figure 2), so only about 10% of workers in this age group approaching retirement have balances over $100,000.
Figure 2 ICI Research Perspective, VOL. 17, NO. 10, December 2011, p. 13.

Is $100,000 enough? The following are some estimates provided by the aforementioned Aon Consulting study published in 2008.  These estimates can vary widely depending on what assumptions we make about the household and what we can expect our future investments to earn, but they should give you an idea of what is required.

Lump Sum Amounts Needed at Retirement in Addition 
to Social Security Benefits as a Multiple of Final Pay

Final Annual Pay
Lump Sum Needed for Male
Lump Sum Needed for Female
Average Lump Sum Factor
Lump Sum Needed at Retirement

For example, if you were earning $50,000 the year before retiring, Aon estimates that you would need about 5.1 times that amount ($255,000) saved for retirement. This amount of savings, combined with Social Security benefits, would be required to maintain your pre-retirement standard of living.

(While these estimates may seem like a lot of money, I will show you in a future post that they are actually quite optimistic for anyone retiring in in 2012 when interest rates hover near zero.)

How much you need to retire on depends on your income before retirement. As you can see from the table above, $100,000 of retirement savings is adequate only for workers who earn about $20,000 a year just prior to retirement. 90% of workers in their fifties and sixties have less than $100,000 saved. If they earn $30,000 a year or more, they will experience a decline in their standard of living after they retire. Perhaps a dramatic decline.

The households who expect to have significantly less than the lump sump savings requirements in the rightmost column of the table above for their pre-retirement income level are the ones I refer to as “unwealthy”, because most of them will struggle to maintain their standard of living after they retire.

To be truly wealthy, you need a high standard of living today, but also the ability to maintain that standard of living after you retire. Even if you are earning $90,000 a year or more today, you are facing significant retirement financial struggles if you are approaching retirement with $200,000 saved. That isn’t wealthy. That’s living beyond your means and you will be forced to square the tab after you retire.

Our retirement system is in serious trouble. As the Schwartz Center for Economy of Policy Analysis states the problem, “Even the Highest Earners Don’t Have Enough.” As the table below shows, only those in the top quartile of income levels have significant retirement savings — significant, but not enough.

If you haven’t been able to save enough for retirement, at least you know that you are in the majority.

There is plenty of margin in these numbers. They assume that you will retire at age 62, for example, and if you can work to age 70 and collect larger Social Security benefits, your retirement finance picture will be much better. On the other hand, if you retire at age 62 as many retirees do, you will need much greater retirement savings and your financial picture will be worse. That tells us that there are things you can do to improve your retirement finances no matter how much you have saved.

Furthermore, people in their fifties still have more than a decade to improve their savings.

So, we have a big problem: 90% or more of the largest generation in our country’s history, somewhere between 72 and 79 million strong, is beginning to retire without enough savings to maintain their standard of living.  Many will drop out of the middle class. That’s about a quarter of the U.S. population of 315 million.

As Teresa Ghilarducci, author of When I'm 64: The Plot Against Pensions and the Plan to Save Them puts it, “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.”

It isn’t just the unwealthy households that have a problem. What will happen to consumption in the U.S. economy when 70 million retirees can’t afford to buy anything? What does that mean for the rest of Americans still in the workforce? What does it mean to their 401(k)’s dependent upon stock market performance?

Years ago, economists feared that when Boomers retired they would sell all the stock they owned in retirement accounts and drive down the market. The 2008 market crash and housing crash did that before Boomers could unload their stock. Now, the concern should be that millions of Americans will have little money to spend in retirement and demand won’t be adequate to sustain market growth.

The United States constitutes 5% of the world’s population but incarcerates a quarter of its prisoners. Opponents of excessive incarceration in the U.S. argue that if 2.3 million Americans need to be imprisoned, we must be the most evil country on the face of the earth. I would similarly argue that if more than 90% of American households are unable to save enough for a comfortable retirement, then either we are the largest country of overspending, self-indulging sloths in the world or our retirement system is broken.

Some wag their fingers at Baby Boomers and say they lived beyond their means and didn’t save enough. Did 90% or more of Baby Boomers really live beyond their means?

It seems clear from the results of the first thirty years of this saving and investing regime that, as Teresa Ghilarducci argues in a New York Times opinion piece entitled, “Our Ridiculous Approach to Retirement”, the American retirement system simply doesn’t work.

Stick with my blog and I'll explain the challenges and provide suggestions for how your household might deal with it.