Friday, April 12, 2013

A Million Six Ain't What It Used to Be

An article in the March 2013 issue of Money magazine, entitled “Quittin’ Time”, should be eye-opening if not downright depressing for more than 90% of American workers hoping to retire one day. It discusses the challenges facing two couples that hope to retire with a mere $1.3M and $1.6M in savings.

According to the Employee Benefit Research Institute, about 90% of American workers approaching retirement have less that $200,000 saved for retirement, and about half of those have no meaningful savings, at all. I suspect those households will have difficulty mustering sympathy for the Vick and Edwards families.

Two things should catch your eye. First, households that have saved $1.3M and $1.6M are struggling with retirement financing. And second, the family with $1.6M is actually in worse shape.

I recently worked with a client who is nearing retirement and on track to save about $1.2M if the stock market gods don’t get angry in the next few years. We found that family is in pretty good shape and probably better off than the Vicks or the Edwards.

What’s the difference?

The amount of money that you need to save for retirement depends heavily on two factors: how large your Social Security benefits will be and how large a percentage of your savings you will need to spend each year in retirement.

(It also depends greatly on how long you and your spouse will live, but that is beyond our control so we need to assume we will live 30 years or more in retirement just in case we do.)

Notice that successful retirement savings doesn’t depend directly on the amount you save, but on the percentage of that amount you will need to spend annually after you retire.

That should make sense. The math isn’t rocket science. If you spend too much, it doesn’t matter how much you save. But this is one of the reasons we can’t set a general target savings amount for retirement and why $1.2M is plenty for one household and $1.6M isn’t enough for another.

If you live in an area with a low cost of living, have the mortgage paid off and maximize Social Security benefits, you might maintain your pre-retirement standard of living with $300K of retirement savings or less. Different households have different standards of living and the same standard of living has different costs depending, among other things, on where you live.

The Vicks save 12% of their $130,000 annual income every year, or $15,600. They also probably pay about $9,950 a year in FICA taxes. They won’t have either of these expenses after they retire, so let’s assume they will need about $104,000 a year to maintain their standard of living after they retire.

I’m guessing the Vicks will receive somewhere around $36,000 a year in Social Security benefits, which leaves them with about $68,000 a year of expenses to replace from personal retirement savings. That $68K is 5.2% of $1.3M, and 5.2% is a lot of spending if a portfolio needs to last 30 years. If they live long lives, their savings won’t last.

Current studies show that future safe retirement spending rates, based on current capital market forecasts, will range anywhere from 2.5% to 4.5% and, in either case, 5.2% is outside that range. Consequently, the Vicks do have a challenge, even with $1.3M saved.

The article doesn’t provide enough data to run the same numbers for the Edwards family with $1.6M, but his financial planner suggests that at their current rate of spending, they have little chance of meeting their retirement goals. That tells me their spending rate is a good bit higher than the Vick family’s 5.2%, and there’s the difference.

The Vick family is in better shape than the Edwards family, even though they have saved $300,000 less, because they need to spend a smaller percentage of their savings after they retire to maintain their lower standard of living.

The household I recently counseled that is on track to save $1.2M for retirement in the next few years will only need to spend around 4% or less of their savings each year because they live in an area with a relatively low cost of living, so they’re in better shape than either the Vicks or the Edwards.

Still, that’s a butt-load of money, and a lot more than 90% of American workers will have when they retire. If you need a 4% spending rate of your savings in retirement, then you need to save $25 for every $1 you will spend annually for a thirty-year retirement. If you need to spend 2.5% of your savings then you need to save $40 for every dollar you will spend from savings after you retire. You might get by on the former, but even that is more saving and investing than most families are capable of achieving.

Unfortunately, the obvious alternative for inadequate savings is to lower annual spending until it reaches the 2.5% to 4% range on top of Social Security or other pension income, and that means a lower standard of living for the majority of American families after they retire.

(There are other steps you may be able to take if you have inadequate retirement savings and I will cover those in future posts.)

Neither the Vick’s $1.3M nor the Edwards’ $1.6M is anywhere near a retirement slam-dunk for these families.  How much does your household need to save for retirement? It depends on how much Social Security you will receive and how much you will need to spend.

For some households, that will be under a million dollars, but maybe not as far under as you would guess. $200K will rarely do the trick.

The Money article finishes with the Stevens family, who has accumulated about $5M for retirement. You won’t be surprised to learn that their retirement is looking rosy.

I think Jim Edwards summed the situation up pretty well.

“I thought I could retire next week. Evidently, $1.6 million doesn’t go as far as it used to.”

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