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.

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.