Unwealthy

Are you unwealthy?

Is that even a word?

No? Good, let’s make it one. I need a word that describes households that are firmly established in the middle class at present, but won’t have enough retirement savings to avoid a dramatic decline in their standard of living after they retire, possibly falling out of the middle class entirely.

The statistics clearly show that the wealthy can save money for retirement. They have plenty left over from their paychecks after paying the rent, putting food on the table and sending their kids to college. Here are the average savings rates by household income from a 2008 study by Aon Consulting:

The more you earn, the more you have left over to save for retirement in a tax-deferred 401(k). And, of course, the more money you make, the bigger tax break you get from the tax deferral. So, the wealthier you are, the more the government helps you save for retirement. No surprises there.

According to the chart above, households earning $20,000 save $396 a year on average for retirement, while a household with $90,000 of annual income saves $5,013 on average. Since the $20,000 household probably pays no federal income tax, there is no tax deferral to help with their saving. The higher-earning household gets to defer taxes on theirs.

But studies also show that the vast majority of the middle class don’t have adequate retirement savings.

The American retirement system, created in the early 1980’s and based on the concept of typical American households saving and investing in tax deferred accounts to complement Social Security benefits, has failed. About 83% of 401(k) balances hold less than $100,000 (Figure 1). Half of American workers have no retirement savings at all. (Click any chart to enlarge.)

Figure 1 ICI Research Perspective, VOL. 17, NO. 10, December 2011, p. 12.

About 59% of the accounts with balances over $100,000 belong to workers in their 50’s and 60’s (Figure 2), so only about 10% of workers in this age group approaching retirement have balances over $100,000.

Figure 2 ICI Research Perspective, VOL. 17, NO. 10, December 2011, p. 13.

Is $100,000 enough? The following are some estimates provided by the aforementioned Aon Consulting study published in 2008.  These estimates can vary widely depending on what assumptions we make about the household and what we can expect our future investments to earn, but they should give you an idea of what is required.

Lump Sum Amounts Needed at Retirement in Addition 

to Social Security Benefits as a Multiple of Final Pay

Final Annual Pay	Lump Sum Needed for Male	Lump Sum Needed for Female	Average Lump Sum Factor	Lump Sum Needed at Retirement
$20,000	4.0	4.5	4.3	$85,000
$30,000	5.0	5.5	5.3	$157,500
$40,000	5.0	5.5	5.3	$210,000
$50,000	4.8	5.4	5.1	$255,000
$60,000	5.2	5.7	5.5	$327,000
$70,000	5.6	6.3	6.0	$416,500
$80,000	6.1	6.8	6.5	$516,000
$90,000	6.8	7.5	7.2	$643,500

For example, if you were earning $50,000 the year before retiring, Aon estimates that you would need about 5.1 times that amount ($255,000) saved for retirement. This amount of savings, combined with Social Security benefits, would be required to maintain your pre-retirement standard of living.

(While these estimates may seem like a lot of money, I will show you in a future post that they are actually quite optimistic for anyone retiring in in 2012 when interest rates hover near zero.)

How much you need to retire on depends on your income before retirement. As you can see from the table above, $100,000 of retirement savings is adequate only for workers who earn about $20,000 a year just prior to retirement. 90% of workers in their fifties and sixties have less than $100,000 saved. If they earn $30,000 a year or more, they will experience a decline in their standard of living after they retire. Perhaps a dramatic decline.

The households who expect to have significantly less than the lump sump savings requirements in the rightmost column of the table above for their pre-retirement income level are the ones I refer to as “unwealthy”, because most of them will struggle to maintain their standard of living after they retire.

To be truly wealthy, you need a high standard of living today, but also the ability to maintain that standard of living after you retire. Even if you are earning $90,000 a year or more today, you are facing significant retirement financial struggles if you are approaching retirement with $200,000 saved. That isn’t wealthy. That’s living beyond your means and you will be forced to square the tab after you retire.

Our retirement system is in serious trouble. As the Schwartz Center for Economy of Policy Analysis states the problem, “Even the Highest Earners Don’t Have Enough.” As the table below shows, only those in the top quartile of income levels have significant retirement savings — significant, but not enough.

If you haven’t been able to save enough for retirement, at least you know that you are in the majority.

There is plenty of margin in these numbers. They assume that you will retire at age 62, for example, and if you can work to age 70 and collect larger Social Security benefits, your retirement finance picture will be much better. On the other hand, if you retire at age 62 as many retirees do, you will need much greater retirement savings and your financial picture will be worse. That tells us that there are things you can do to improve your retirement finances no matter how much you have saved.

Furthermore, people in their fifties still have more than a decade to improve their savings.

So, we have a big problem: 90% or more of the largest generation in our country’s history, somewhere between 72 and 79 million strong, is beginning to retire without enough savings to maintain their standard of living.  Many will drop out of the middle class. That’s about a quarter of the U.S. population of 315 million.

As Teresa Ghilarducci, author of When I'm 64: The Plot Against Pensions and the Plan to Save Them puts it, “Almost half of middle-class workers, 49 percent, will be poor or near poor in retirement, living on a food budget of about $5 a day.”

It isn’t just the unwealthy households that have a problem. What will happen to consumption in the U.S. economy when 70 million retirees can’t afford to buy anything? What does that mean for the rest of Americans still in the workforce? What does it mean to their 401(k)’s dependent upon stock market performance?

Years ago, economists feared that when Boomers retired they would sell all the stock they owned in retirement accounts and drive down the market. The 2008 market crash and housing crash did that before Boomers could unload their stock. Now, the concern should be that millions of Americans will have little money to spend in retirement and demand won’t be adequate to sustain market growth.

The United States constitutes 5% of the world’s population but incarcerates a quarter of its prisoners. Opponents of excessive incarceration in the U.S. argue that if 2.3 million Americans need to be imprisoned, we must be the most evil country on the face of the earth. I would similarly argue that if more than 90% of American households are unable to save enough for a comfortable retirement, then either we are the largest country of overspending, self-indulging sloths in the world or our retirement system is broken.

Some wag their fingers at Baby Boomers and say they lived beyond their means and didn’t save enough. Did 90% or more of Baby Boomers really live beyond their means?

It seems clear from the results of the first thirty years of this saving and investing regime that, as Teresa Ghilarducci argues in a New York Times opinion piece entitled, “Our Ridiculous Approach to Retirement”, the American retirement system simply doesn’t work.

Stick with my blog and I'll explain the challenges and provide suggestions for how your household might deal with it.

Statisticians Make the Worst Clients

(This post originally appeared on Dr.Wade Pfau's Retirement Researcher Blog.)

A new client came to my office a few weeks ago, a statistics professor from the local university who had been referred to me by a mutual friend.

After a bit of small talk about our buddy, I asked how I could help.

“I have a million dollars in my 401(k) and I’m about to retire,” he informed me. “How much of that can I spend each year?”

“Well. . .”, I told him, “we financial planners like the Safe Withdrawal Rate Strategy. Invest your savings in a diversified portfolio of stocks and bonds and you can withdraw 4.5%, or $45,000 a year in your case, increased by the rate of inflation every year. Do that and your portfolio has a 95% chance of surviving for thirty years!”

He wrinkled his brow a bit.  “95%? What’s safe about that?”

Taken aback, I responded, “95% sounds pretty safe to me!”

“You are aware that the bankruptcy rate for Americans aged 65 and over is about 4.3 per thousand?”
“Well, yes. . .”, I stammered, “I mean, no. . .”

“That’s an average success rate of 99.6% for all retirement-aged Americans. 95% would be 12 times riskier than the average for my age.”

“Well, let me explain how it works,” I insisted.

I described the Trinity study and several since, about how they used rolling 10-, 20- and 30-year periods of market returns and how they keep subtracting a fixed withdrawal rate every year until they either reached the end of the 30-year cycle or depleted the portfolio.

He wasn’t persuaded.

“So, you’re telling me that these are the probabilities of success for retirees who would just keep spending the same amount every year, even when they were obviously approaching financial ruin? What does that have to do with me? I'd stop spending if I thought I was going broke. Wouldn’t you?”

“How does that matter?” I asked.

“That’s referred to as the unrepresentative sample fallacy,” he explained. “It’s like trying to infer the average height of Americans from the heights of NBA basketball players. You’re trying to infer a portfolio survival rate for the general population of retirees from a sample of people who would do nothing to avoid going bankrupt.”

I was beginning to think I didn't want any more statisticians for clients. Certainly not pedantic ones.

“Besides,” he added, “these study results clearly show that you can withdraw 4.5% of your portfolio value when you retire, then you can increase the withdrawal to about 6% of whatever savings you have left with 20 more years of retirement, and then increase withdrawals slowly to about 10% of whatever savings you have left at ten years. You can’t keep taking percentages of your original portfolio balance — finance doesn’t care how much money you used to have."

"Yes, but. . ." I countered.

 "You seem to think the withdrawal rates are somehow locked in on the day you retire. Why do you think those studies imply that I could withdraw the same amount every year, even if my portfolio drops in a bear market?”

“Because everyone says so!”

Finally, I had him.

“Here! Right here in Money magazine a few years ago." I thumped the magazine three times with my index finger for emphasis. "Walter Updegrave said it. He said it often, as have a lot of other people:”

“Withdraw no more than 4% of your portfolio the first year of retirement and then increase that amount for inflation each year and there will be roughly a 90% chance that your money will last at least 30 years.”

“So, now it’s 90%? That’s 24 times worse than average. But, regardless, Walter is wrong,” he insisted.

I had to admit that ole’ Walt had softened that statement a great deal since all those retirees lost their shorts in the 2008 market crash. Even Scott Burns, who wrote column after column praising SWR for the Dallas Star now calls that rule of thumb a “rule of dumb”. I decided to keep that to myself for now.

“You realize the numbers predicted by your SWR studies are a priori probabilities, right?”

The guy was really starting to get on my nerves.

“A priority, B priority. I never paid much attention to that stuff,” I replied.

“No, it’s a priori, not priority. It means those are the probabilities of success before retirement starts. After retirement begins and your portfolio goes up or down because you spend part of it or the stock market went up or down, those probabilities change.

You have a new conditional probability of success depending on how much longer your retirement will last and how much money you have left. If you want to keep your 95% probability of success throughout retirement, you'll have to spend less when your savings decline and you can spend more when they increase.”

“So?” I asserted with my best Dick Cheney false bravado.

 “So, that means you can’t predict how much money you will be able to spend in the future, because you can’t predict the balance of your portfolio. And isn’t that what you were trying to do all along? Withdraw a steady, predictable amount from a volatile portfolio?”

“Think of it this way,” he said as he pushed back his chair and stood up. “Let’s say 10,000 airplanes have left from San Francisco flying to Hawaii in the last several decades and 99% have successfully reached the islands. Every plane that takes off on that flight, based on historical data, has a 99% chance of success, right?”

“Sure”, I answered.

“So, if you're on that flight and a wing falls off over the Pacific Ocean and you are barreling into the sea, you should take very little comfort from the fact that your odds of reaching Honolulu were once 99%. You are now pretty firmly locked into that 1%.”

As he said this, he took his coat and headed for the door.

"And if you lost over half your portfolio in the 2008 market crash, you can't just keep spending like you used to have a lot more money — if you do, say hello to your new neighbors, the 5%."

“Wait!” I yelled. “We didn’t discuss your retirement plans!”

I’ve tried to reach him several times since to reschedule, but the guy won’t return my calls.

Maybe it was something I said.

Don't Forget Health Care Costs

I retired about seven years ago with meticulous financial plans. The bad news is that I have already encountered huge bumps in the financial road that no one could have foreseen and the good news is that I am somehow miraculously still on plan.

Thankfully, I did foresee that there were huge risks I would not be able to foresee and I planned for that by building lots of safety margin into my plan.

Someone once told me that there are known unknown risks (things that you know you don't know) and unknown unknown risks (what you don't know and don't know that you don't know) and it's always the unknown unknowns that get you. If that makes sense to you, then retirement planning will be a breeze.

A 56% decline in the stock market three years after I retired was the worst-case scenario and I got to experience it. (Word to the wise: my savings survived because I had a very heavy dose of bonds and cash.) Many weren't so lucky. Then one of my kids decided to become a doctor and got into med school. Didn't see that one coming.

Perhaps the biggest shock, though, has been the cost of health care. It's higher for me because I'm retired but have three kids in college, but I did foresee that.

According to a report in the New York Times today entitled Planning for Retirement? Don’t Forget Health Care Costs, for a 65-year-old couple retiring this year, the cost of health care in retirement will be $240,000 and that number is growing rapidly. That's about three times the median value of a 401(k) account for households approaching retirement. In other words, it's three times as much as most households have saved to pay for all retirement expenses.

The first problem with health care after retiring is simply finding someone who will insure you at a reasonable rate, or at an unreasonable rate for that matter. With a lot of research and a little finagling  I found policies for the five of us, but found the best approach was to get different policies from different carriers for each family member.

(Anyone who thinks they can get a voucher from the U.S. government and find someone to sell them health insurance after the age of 50 clearly doesn't understand the situation.)

When you reach age 65 you will be eligible for Medicare (at least I hope we will). That will be a huge help but it doesn't solve the problem. We tend to imagine that Medicare coverage will be similar to what we received from our employers, but it is not. According to the Employee Benefit Research Institute, Medicare covers only 51% of all medical services. Most households buy Medigap policies to cover the shortfall and that cost needs to  be built into your budget.

The Times article quotes a financial expert as recommending that you budget 5% of you income for health care costs, but that seems optimistic to me.

More details are available in the Times article. I will simply say that health care costs are a major risk to your retirement finances and often fall into the category of unknown unknowns from several perspectives.

The availability of health insurance, if your employer provide it, is another financial benefit of delaying retirement.

Estimate your retirement health care costs as best you can. And build in a lot of safety margin.

Estimating How Much Income You Need to Retire

Is 70% of your pre-retirement salary a good rule of thumb for estimating how much income you will need after you retire? How about 80%?

Though these are the guidelines frequently suggested by financial planners and writers, household income replacement ratios actually range from about 75% to about 95%, depending on how much you earn (see chart below created from a 2008 Aon Consulting  study). Oddly, the replacement ratio is highest when your household income is very low or very high, and lowest when you make $70,000 to $80,000. 

(Click any chart to enlarge.)

The replacement ratio is the percentage of your final working salary that you will need to maintain your standard of living in retirement. Once you stop working, that percent of your final salary will need to be replaced by Social Security benefits, personal retirement savings¹ and other sources of income.²

Based on the Aon numbers, 70% and 80% of pre-retirement income are not good estimates. You can see from the chart above that 70% never seems to work and 80% only works between about $50,000 and $120,000 of income. Earn more or less and 80% can be way off.

So, should we replace the 70% and 80% rules of thumb with the Aon tables?

Here’s the thing. Replacement ratios by themselves aren’t very interesting. As soon as someone says that you will need to replace say, 85% of your pre-retirement income when you stop working, you’re going to ask, “OK, so how much of that will Social Security cover?”

Because that’s what you really want to know, isn’t it? How much is your shortfall, or the amount of retirement income you will need that isn’t covered by Social Security?

The Aon study estimates shortfalls, too, and Social Security benefits. It even estimates your retirement savings, because you don’t have to contribute to retirement savings after you retire. So, if you’re earning $60,000 a year before you retire and you’re savings $10,000 a year in a 401(k), you only need $50,000 to maintain your standard of living after you retire.

From Aon Consulting report 2008.

Shortfalls, or the percentage of your retirement income that will not be covered by Social Security benefits, are indicated by the lighter blue stacks labelled "Other Sources" in the chart above.

Both the Social Security benefit and retirement savings assumptions have dramatic impacts on the shortfall that you calculate. The Aon Consulting study uses the average savings rate for each range of income, but we know that the average retirement savings rate is a pretty useless statistic.

Half of Americans about to retire have no retirement savings at all. Mitt Romney, on the other hand, reportedly has an IRA worth somewhere between $20M and $100M, and there are no doubt other very large IRA's at most income levels that distort the averages. That's why the median retirement savings account balance is much lower than the average at most income levels.

Your household may save a lot more or a lot less than the average for households with your income and that can throw off rules of thumb and the Aon estimates by a lot.

Similarly, Social Security benefits can vary widely between two households with the same income. The Aon study assumes that the household consists of a one-earner couple that will retire at full retirement age. Such a couple with an income of $50,000 just before retiring would receive an estimated $25,295 per year in Social Security retirement benefits. This is the Aon base case.

But a single retiree earning $50,000 and electing to receive benefits at age 62, as the majority or claimants do, would receive just $12,276 a year, and a couple delaying benefits until age 70 would receive over $32,000 a year. That creates a huge range of shortfalls.

The Aon tables provide a more accurate estimate than the 70% and 80% rules of thumb because they take income levels into consideration, but they don’t consider a range of Social Security benefits or savings rates, so they can still be highly inaccurate.

Ignore rules of thumb when planning for retirement. Either method can provide a dangerously incorrect estimate of your income requirements. At best, tables and rules of thumb are very broad generalizations. I recommend you calculate your own shortfall. I explain how to do that in my post, Closing the Shortfall — How Much to Save for Retirement.

With your shortfall you can calculate how much you need to save for retirement.

In my next couple of blogs, we'll look at how much personal retirement savings you will need to cover your shortfall.

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¹ 401(k) accounts, IRA’s, etc.

² Part time employment, a pension, rental income, etc.