Thursday, December 13, 2012

Why You Didn't Save Enough for Retirement

How did I know that you didn’t save enough? I guessed — but I had about a 95% chance of being correct. Hardly anyone has been able to save enough.

According to the Schwarz Center for Economic Analysis, “Americans ages 50-64, 58 million of them in 2010, will likely not have enough retirement assets to maintain their standard of living when they reach their mid-sixties.

The median retirement savings balance for workers aged 50 to 65 was recently about $78,000. That will purchase an annuity that pays less than $4,000 a year. Before inflation.

Over half of near-retirees have no retirement savings at all. Baby Boomers are in bad shape. GenX’ers are worse off.

How did we end up in this mess?

In the 1980’s, politicians and corporations shifted responsibility for managing our retirement savings from professionally managed corporate pensions to defined contribution plans like 401(k) accounts and IRA’s. Grandpa's pension plan became your 401(k). In doing so, we lost the pension plans’ ability to pool longevity risk without adverse selection problems.

That’s a fancy way of saying that pension plans have a large number of participants who retire at different times and have different probabilities of living longer-than-average lifetimes. You have you.

It’s much more difficult to prepare for retirement as individuals than as a very large group of people, like members of a large pension plan. It’s a little like being responsible for your own auto risks instead of being able to buy insurance.

The assumption was that a typical family could save enough money and invest it well enough to pay for retirement. The results of the first 30 years of this experiment are not promising.

What went wrong?

1. Covering 95 years of expenses with 40 years of salary is hard to do.

Several things explain the low levels of successful retirement savings. First and foremost, earning enough money to support a family over a forty-year working career is challenging enough, but our system requires that you also save enough, perhaps 20% to 25% of every pay check, during that career and invest it well enough to pay for thirty or more years of retirement.

Baby Boomers have longer life expectancies than previous generations. Life expectancy increased about 30 years over the past century, but these additional years are tacked on to the end of our lives when chances for continued employment rapidly diminish. In other words, a longer life expectancy doesn’t increase the number of earning years to nearly the extent that it increases the number of years we have to pay for.

2. No one earns average stock market returns for very long.

Even if you invest your savings well, it’s difficult to accumulate the roughly 8 times annual income you will need in addition to Social Security benefits to pay for retirement.

By “investing well”, I am referring to the assumption that 401(k) plans will experience the same investment returns as stock market averages. I’m not sure who thought that was a good assumption, since even professional investors can’t achieve market average returns for more than a few consecutive years.

While the market returns a long term average of 8% to 10% a year depending on the time period measured, repeated studies have shown that the typical mutual fund investor earns no more than 2.5% annually.

3. You picked a bad time to be born.

It will probably come as a surprise to most people that the largest factor determining their lifetime investment performance is when they were born.

The amount you earn on your investments depends largely on when you retire and when your career begins. When your career begins depends largely on when you are born, an event over which we have no control.

If the market performs well for the 30 or so years of your career, your investments will probably perform well. You will be swimming with the current (a bull market). If the market performs poorly for that 30 years, your investments are unlikely to do well because you are swimming against that current.

If your career ended in 2000, you could have earned a lot in the stock market. If you retired in 1921, though, your stock market gains were pretty much screwed the day you were born, although you wouldn't have learned that for another 65 years.

The market has not been kind for the past two decades or so. Financial expert William J. Bernstein recently commented in a Money magazine interview about reaching the magic number for retirement savings:

“The last cohort 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.”

4. Life happens.

Even if you can save an enormous chunk of your paycheck for 30 years and invest it wisely, you may encounter big setbacks along the way: layoffs, huge medical expenses, college for a couple of kids. Although we shouldn’t borrow our retirement savings to survive these emergencies, often there is no alternative.

5. Nobody told you.

I don't remember anyone telling me when my career first started out that I would need to accumulate at least 8 times my annual pre-retirement income in order to pay for retirement. I learned that after I became a financial planner, earned an MBA, and after I retired and read lots of academic papers on the subject.

I suspect the vast majority of workers had (or still have) no idea how much money they would need to save because it's a difficult number to predict, even now. You might not have saved enough because you simply didn't know how much you would need to save. 

Not the reason.

One reason that I don’t buy for the failure of so many retirement plans is the common refrain that “Boomers didn’t save enough”, as if it is some kind of personality flaw afflicting an entire generation. First, Boomers are in better shape than GenX’ers and no previous generation was asked to accumulate so much wealth for retirement.

Second, I know far too many families that live in modest homes, drive older cars, worked hard their entire lives, husband and wife, raised a family and sent a couple of kids to college, but weren’t able to adequately save for retirement. Calling these families irresponsible is grossly unfair.

So, there you have it. If you weren’t able to save enough for retirement you are, sadly, far from alone. Very few households can succeed at a game that is nearly unwinnable, but that is the system we have at present.

Rather than bemoan this tragedy, however, I strongly recommend that you do some planning and make the very best of a difficult situation. Maximizing your Social Security benefits is a must, for example, and that means postponing them as long as you can.

I created this blog to help.

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