Tuesday, June 30, 2015

Retiring Early: Lost Savings

In my last post, The Risk of Retiring (or Being Retired) Early, I provided some thoughts about the risk of retiring early and perhaps extending what would already have been a long and expensive retirement. A second risk of retiring early is that we will stop saving for retirement sooner.

As the savings, or “accumulation", phase of retirement progresses, the contribution of new savings to our net worth becomes progressively smaller as the contribution from existing portfolio growth increases. Consider the following three graphs. First, our earnings tend to grow from the beginning of our careers, peak in our mid-fifties and then decline a bit each year until we retire.

Assuming a retiree saves 10% of earnings annually until retirement, annual savings contributions would look like the following curve. Note that by retiring early, we stop saving when our annual contributions are near their peak around age 55 to 60. On the plus side, we're robbing our own savings at a time when their potential compounded growth is relatively low because they have fewer years left to grow than did our early-career savings.

Assuming this retiree earned a consistent 7% rate of return on her portfolio, the contribution at each age to her portfolio value from new savings is shown below in red and the contribution from investment returns on previous savings contributions is shown in blue.

The graph above shows that if we retire early and stop saving at age 60, for example, the value of the lost savings is probably a lot smaller than the return we will continue to receive on our portfolio, but the loss can still be substantial.

The following chart shows the results of retiring at ages 55, 60, or 65 instead of age 70, using the same assumptions as above, but assuming that contributions stop at retirement age and that we don't start spending from the portfolio until age 70. (I will discuss the impact of early spending from savings in my next post. For now, let's just look at lost savings.)

If this person retired at age 70, he would save $1,832,840. Stopping annual savings at age 65 would reduce the portfolio balance by 3.3%. Stopping savings contributions at age 60 would reduce it by 8.3% and stopping at age 55 would reduce the portfolio balance by 15.5%. Reducing the size of your retirement savings portfolio balance reduces sustainable retirement spending by the same percentage. Reduce your portfolio balance by 3.3% and you reduce your sustainable spending amount from your risky portfolio by 3.3% annually.

Note again that reducing savings by retiring early has a significant impact on a retiree's finances, but that most portfolio growth late in our careers comes from market returns on our accumulated savings and not new savings contributions. On its own, losing a few years of savings contributions is tolerable.

The problem is the two-edged sword created by stopping additional annual savings early and beginning portfolio withdrawals early. I'll look at the latter next time.

In the meantime, Wade Pfau is holding a free retirement planning webinar on Wednesday, July 1st at 5:00 pm ET. You can sign up for it here.


  1. I enjoy the posts. My own look at retirement finance agrees with the above. Retirement duration has an outsized effect on what you can spend. Retirements over 30 years see some serious degradation in what one can likely safely withdraw. In addition to the endgame being a probability distribution (and a moving one at that) that's hard to predict, for a lot of people the retirement start date is a little bit random as well. A study by some financial company (not sure on how credible or recent it was but it speaks to the issue) showed that 60% of the survey population said the timing of their retirement was unexpected and 33% said it was more or less involuntary (health issues, getting fired, caring for others, etc). Either way, voluntary or involuntary, the risks of long retirements are high and probably quite a bit under-appreciated but I'd say it's probably a lot tougher to swallow when one does not have a choice.

    1. Thanks. The information you refer to is part of an annual survey done by the Employee Benefit Research Institute, and the number of retirees who report that they weren't able to retire when planned appears to be growing. The research is both credible and recent.

      Thanks for writing, Will!

  2. Thanks. I looked back and found I was using a Voya Financial report from an article I had read. Maybe it was based on the same underlying research. I also now see your prior post that touches on unplanned early retirement.

  3. " On its own, losing a few years of savings contributions is tolerable." but "Reducing the size of your retirement savings portfolio balance reduces sustainable retirement spending by the same percentage. Reduce your portfolio balance by 3.3% and you reduce your sustainable spending amount from your risky portfolio by 3.3% annually."
    Isn't this significant? If one should safely spend, say, 3.5% per year and then by retiring at age 60 stops savings contributions by 8.3%, would one have a negative spending rate? What am I misunderstanding? Perhaps an example would help. Thanks.

    1. No negative spending rate. I think you're comparing percentages of one amount when they should be applied to two different amounts.

      3.5% spending in your example would mean 3.5% of your portfolio value at retirement. In my example, that would be 3.5% of between $1.5M and $1.8M. An 8.3% savings contribution would be 8.3% of your annual salary during those last years of your career, which is probably less that $1.5M to $1.8M per year (if it's not, call me!).

      As the third chart above shows, your retirement portfolio value depends more on your savings to date late in your career (blue) than it does on new savings contributions (red) in those years.

      I didn't say the spending reduction was insignificant, I said it was "tolerable." If it were the only cost of retiring early, it wouldn't be so bad. Unfortunately, it isn't the only cost.

      Again referring to the third chart above, the spending you would lose by retiring early is about 3.5% of the red area to the right of your retirement age, but you'd get to spend about 3.5% of the blue area. Losing 3.5% red isn't nearly as painful as losing 3.5% of blue.

      Does that help?

    2. When I reread the paragraph in your post where you talk about this I can't make sense of it, but your explanation makes total sense. Thanks.

    3. Excellent. I'm not perfect and I appreciate people asking me to further explain anything that might be confusing. Thanks for writing!