Friday, November 30, 2012

A Retirement Funding Primer

Most Americans begin their careers at roughly age 25. It’s difficult for most young people to save much for retirement when they first start out, so for retirement planning purposes we typically assume that you will begin saving seriously around age 30.

Most Americans retire somewhere around age 65. About a fourth of us will live into our nineties. Most of us will not, but when you’re planning for retirement you need to assume you will live to about age 95 or even 100.

If you die sooner, retirement will be shorter and less expensive of course, but counting on dying before you run out of money is not much of a plan. Growing very old and very broke is what economists might call an “undesirable outcome”, so we plan for the worst financial case. It’s far better to plan for a long retirement and to leave unused savings to your heirs than to plan for an average length retirement and die broke.

This means that we will work for roughly 35 years and be retired for as long as 35 years, and that means that we have to earn enough in the first 35 years to not only pay for our living expenses then, but also to sock away enough savings to pay for the last 35 years.

That may sound like everyone needs to work for 35 years to pay for 70 years of living expenses, but it isn’t quite that bad (you only need to save about 15% to 20% of your paycheck, which is still daunting), because we have three things to help us, Social Security, personal retirement savings and a reduced cost of our standard of living.

During our careers, we pay (and complain about) FICA taxes of a little over 7% of our paychecks. About 6% of that amount is to fund Social Security and the rest funds Medicare. In a way, FICA taxes are forced retirement savings, because in return for paying them we are eligible for Social Security retirement benefits when we reach age 62, realize that we would be broke without Social Security, and decide that paying FICA taxes wasn't such a bad deal, after all.

Social Security replaces part of our pre-retirement work income. It replaces a larger part for lower-earners than for higher-earners, as you can see from the following table from Aon Consulting (click for a PDF of the report). The second column estimates how much of your pre-retirement income that Social Security will replace.

Social Security is intended to keep elderly Americans from falling into poverty after they must stop working, not to maintain the standard of living they enjoyed before retiring.

The second factor that protects us from having to earn two incomes before retirement is personal retirement savings. We can save money in taxable accounts, 401(k) accounts and IRA’s with deductions from our paychecks while we are working. Our savings are increased in two ways.

First, the IRS gives us tax incentives to save in tax-deferred accounts like 401(k) plans and IRA’s, so the government boosts our retirement savings with tax dollars (to a maximum of 6% of income). Second, the money we save earns interest that compounds and increases our retirement savings if our investment in these plans grows adequately.

(That’s a big "if".)

The third reason we don’t have to save an entire second income as we work is that we can buy the same standard of living after we retire for less money. We no longer pay FICA taxes on our income and we no longer have to save for retirement, for example.

Assume you earned $60,000 a year before retiring and look at the fifth row of the table below. (I'll repeat it to save you scrolling.)

A typical household with your income would need to replace 78% of that $60,000 ($46,800) to maintain their standard of living, according to Aon Consulting’s study. Social Security might replace about 46% of that $60,000 ($27,600). The rest (32% of $60,000, or $19,200 per year) would need to come from personal retirement savings.
These are percentages of pre-retirement income. Looked at as a percentage of their new post-retirement income of $48,800, Social Security might provide about 59% of your retirement income and 41% would need to come from savings.

Social Security is the most secure component of retirement income. More than half of American workers have no personal retirement savings, at all, and they will be forced to lower their standard of living after they retire.

There you have it in a nutshell. You work 35 years and pay FICA taxes and save for retirement. Then you retire for up to 35 more years and live primarily off Social Security benefits and your retirement savings.

It isn’t a great system. I’ll explain why in my next post.

Monday, November 19, 2012

The Retirement Savings Game — Chutes and Ladders

There are lots of websites that claim they can tell you if your retirement savings are “on track”. Just look up your age in a table and they’ll tell you how much you should’ve saved by this point in your career to avoid a decline in your standard of living after you retire.

Take them with a grain of salt.

Dr. Wade Pfau performed statistical analysis that shows it’s extremely difficult to predict whether or not your retirement savings are on track even five or ten years prior to retirement, let alone twenty or thirty. You can read his work here, but I’ll provide a taste of his findings.

Here are two retirement savings paths based on historical stock prices. The red path belongs to a hypothetical person who would have retired in 1921. The blue savings path belongs to a hypothetical person who would have retired in 2000. The following chart shows where their savings balances would have been just 10 years prior to retiring. Would you guess that:

a)     Both retirees meet their retirement savings target of 8 times final salary
b)     Neither makes the target
c)     Only red makes his target
d)     Only blue makes his target
Let’s look at savings levels five years later, just 5 years before retiring. Can you pick out the winner(s), yet? Blue seems to be leveling off and red appears to be surging.

Now, let’s look at the retirement day savings balances for the 1921 and 2000 retirees just five years after the previous chart.

The person who retired in 2000 actually overachieved her target, but the poor 1921 retiree missed his target by 50%.

Why did this happen? Because retirement savings grow exponentially. They need to double in the last ten years of your career. If they do, you can win big. If they don’t, you can miss big.  Both retirees appeared to be on track until the last five years of their careers.

The moral of this story, and the point of Pfau’s study, is that it’s nearly impossible to know if you are on track with your retirement savings until just before you retire.

Saving for retirement is a little like playing Who Wants to be a Millionaire. Every year you are asked another question (“How much will I make in the stock market this year?”). You can make it all the way to the last question and lose most of your winnings if you can’t answer the last one correctly, too.

But, I think it’s more like that game from my childhood, Chutes and Ladders
In this game, you spin an arrow on a numbered wheel to progress from square 1 to square 100. Land on a square like 4 and you get to jump ahead to square 14. But, land on a square like 62 and you slide all the way back to 19.

Notice the chute that starts in square 87. This represents retirement savers who had nearly achieved their goal just before the market crash of 2007-2009. I remember square 87 vividly from my childhood. I’d be way ahead of my little sister and suddenly way behind. It sucked.

How do you win Chutes and Ladders as a retirement savings game? There are a few of ways to improve your odds.

First, by reducing your stock exposure ten years before you plan to retire, you shorten both the ladders and the chutes. You avoid a big loss but give up some growth potential. Ten years before retirement, reduce your stock holdings to 50% of your portfolio, 60% at most.

Second, as William J. Bernstein advises, if you reach your savings goal, stop playing the game (get out of the market). My sister wouldn't let me quit Chutes and Ladders when I was ahead, but as a contestant on Who Wants to be a Millionaire, you could leave with your winnings at any time. 

Imagine how the contestants felt who could have left with several hundred thousand dollars of winnings but lost it on the next question trying to hit a million, or older workers who had enough savings before the 2007 market crash and now can't retire.

Third, also from Bernstein, you can save every penny until you meet your goal, knowing that you could lose in the last ten years -- never stop saving. 

These moves improve your odds, but they don’t guarantee you will win.

Like Chutes and Ladders and Who Wants to be a Millionaire, it’s pretty easy to lose the retirement savings game in the final stretch.

Thursday, November 15, 2012

How Much to Save for Retirement – Part 2

Having possibly shocked you in my previous blog by showing you the hundreds of thousands of dollars you need to save in total to maintain your standard of living after you retire, we can now proceed to how much of each monthly paycheck you need to save to accumulate that much wealth.

I wish I could tell you it’s a more appealing story.

Perhaps you believe that the 6% you stash in your 401(k) plan is enough. Unfortunately, that isn't the amount you need to save, it's only the amount that the Federal government allows you to save in a tax-deferred retirement savings account.

Starting with the same approach I used to look at total savings required, let’s first look at the retirement savings rate guesstimates of a few experts. Let’s assume you will need to replace 50% of your pre-retirement income from personal savings and Social Security retirement benefits will replace the rest. (That’s a good assumption in the $40K to $60K income ranges. You would need fewer savings with lower salaries and more at higher.)

Table 1. Estimates of Retirement Savings Needed 
(Percent of income, including any company match.)

Start Saving at Age:
Aon Consulting
Forbes magazine

Trust me, you don’t want to know.

Because savings balances grow exponentially, beginning to save past age 35 requires you to save an enormous chunk of your take-home pay. Pfau, for example, estimates that if you begin saving at age 45, you’d need to save about 36% of each paycheck. So, I’ll stop my table at age 35 and simply say that if you start saving much later than that, you’re probably screwed.

Given that we need to save somewhere around 15% of our take-home pay every year of our careers until our mid-60’s, how much are Americans actually saving?

It depends on your income level, of course. If you make lots of money, it’s easier to save lots of money than if you’re scrimping by to pay the mortgage and help a kid through college. But, here are the averages according to an Aon Consulting study.
Nothing close to 15%, right? Not even for high-earners. And those numbers are for workers who have a 401(k) plan. About half of workers are saving nothing at all for retirement.

Conservatives love to say, “Boomers didn’t save enough”, but a study from the Employment Benefit Research Institute shows that Gen-X’ers are even less prepared for retirement. And according to financial guru William Bernstein,

The last cohort [demographic group] that actually was able to make their number started their careers in 1980, and they made their number in 19 years. And the graph ends in 1980, because no cohort that started work after 1980 actually made the number.”

My favorite Bernstein quote on saving for retirement, and the best advice you will receive anywhere on the subject, comes from his book, The Investor's Manifesto, in which he says,

"First, save as much as you can, start as early as you can, and don't ever stop."

The fact is only wealthy people can save at rates like these. Our current retirement system is failing us miserably. But this blog is for the unwealthy, so stick with me and I’ll explore what you can do to make the best of a bad situation.

You can get more information from my book, Retiring WhenYour 401(k) Fails.

Tuesday, November 13, 2012

How Much to Save for Retirement – Part 1

When someone asks me how much they should save for retirement, they generally mean one of two things. Some mean to ask, “What is the total amount of savings I will need when I am 65 to maintain my pre-retirement standard of living?”

Others are actually asking how much of their paychecks they should be saving to accomplish the same.

Let me first answer both questions more honestly than probably anyone has responded in the past.

I don’t know. No one does.

There are too many unpredictable variables to make a guess with any accuracy, like how high interest rates will be when you retire, how much annuities will pay out and what the stock market will do between now and then. Then, there’s how much money you will be earning before you retire, whether or not you will be married, divorced, widowed or single and what financial setbacks you may suffer along the way. None of these is predictable with any accuracy and we would need to predict all of them.

As you get closer to retirement, these variables will become clearer, but from decades away, they are anything but.

Nonetheless, guess I shall. 

Let’s look at the first question, the total amount you will need to have saved by age 65 or so, and what various experts believe the answer may be. Remember that this is the amount of savings, in your 401(k) for example, you would need, in addition to Social Security benefits and other pensions, to maintain your pre-retirement standard of living after you retire.

Social Security Will Provide Part of Your Retirement Income

How much of your income will Social Security retirement benefits replace after you retire? The benefits are progressive. They replace more of your income if you are a low wage-earner than if you are a high wage-earner. Column two of the following table from an Aon Consulting report provides an estimate of the percentage of your pre-retirement income that Social Security should replace at various income levels.

For example, assume your income was $20,000 a year just before retiring and read the percentages from the first row of this table. Aon Consulting estimates that you will need to replace 94% of your pre-retirement annual income ($18,800) to avoid a decline in your standard of living after you retire. 69% ($13,800) will come from Social Security benefits and you will need to come up with the other 25% ($5,000) from personal retirement savings.

Retirement Savings Are Needed to Fill the Gap

Column three of the table above shows the gap between the income you will need in retirement (column 4 times column 1) and the amount that Social Security will provide (column 2). This is referred to as your shortfall.

Several financial experts have used estimates like this to calculate how much you would need to save by the time you retire to cover that income shortfall.

Table 1. Retirement Savings Needed in Addition to Social Security Benefits and Other Pensions to Maintain Pre-Retirement Standard of Living at Various Final Income Levels

Estimated Retirement Savings Needed
Income the Last Year You Work:
Ibbotson Guess
Aon Consulting Guess
AARP/Anne Thompson Guess
Money Magazine[1] Rule of Thumb

As I give you a minute to pick yourself off the floor, let me say that hardly anyone has actually saved this much. Only about 10% of all 401(k) accounts have balances of $200,000 or more. Half of Americans don’t have any retirement savings, at all, but that’s a topic for another post.

Also remember that the purpose of this blog is to help you make the most of retirement if you don't have enough saved.

Since these figures are so ridiculously different, I will offer an opinion that the best guesses are probably somewhere between Morningstar in column two and Aon Consulting in column three.

What Can We Learn from these Estimates?

At least these three things:

1. The fact that many experts calculate widely varying savings target amounts shows that the "correct" amount is incredibly difficult to predict.

2. No matter which expert is correct, hardly anyone will be able to save enough for retirement. These targets are much higher than the amounts most Americans have been able to accumulate for retirement since defined benefit pensions were converted to 401(k) plans in the 1980's. The typical 401(k) balance is about $78,000 today and, as I mentioned, fewer than 10% of those accounts are valued at $200,000 or more.

3. These are amounts we need to save in addition to Social Security benefits, so if those benefits go away or are significantly reduced, we would turn a ridiculously challenging savings target into a clearly impossible one. As you can see in column two of the table from Aon Consulting above, those savings targets assume that Social Security benefits will replace from about half (if you earn $90,000 a year) to three-quarters of your retirement income if you earn $20,000 a year.

You could calculate your own target savings amount by using these replacement rates and an estimate for your expected Social Security benefits. Here's how.

Sometimes, though, people who ask about how much to save for retirement mean, “How much each year?” Translating these estimates of how much you need to save in total to how much you should save each year to reach those totals is even more difficult and unpredictable, but I’ll address that in my next blog, How Much to Save for Retirement – Part 2.

[1] November 2012 issues, p. 70, “Savings Target 12 times income”.