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.

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