It won't be their father's retirement. Today's young and middle age workers are on a crash course toward a retirement crisis. The crisis is the result of a powerful confluence of market realities that will change retirement as we know it.
Our current batch of retirees may not appreciate it, but many current retirees are enjoying the fruits of a combination of positive market outcomes. In short, they have been lucky.
These retirees may be the last of a generation that will enjoy a sturdy three-legged stool of retirement income - a defined benefit retirement, a 401(k) and Social Security.
In addition, for today's retirees, their climate for the growing of wealth was very favorable. Since the 70s and early 80s the stock market has seen P/E ratios grow fourfold, the bond market has seen steadily increasing values as interest rates have fallen from over 10 percent in the early 80s to almost nothing now, housing prices have increased over three times, and inflation has been relatively low. They also benefited from low-cost public colleges and a declining income tax burden.
As a climate to save for retirement, it is difficult to ask for much more. One only has to imagine a world in reverse - an environment where stock P/E was flat or falling, bond yields were increasing not decreasing, housing prices were flat or declining, a world without defined benefit retirement plans, where college cost were 75% higher. If today's retirees had faced those headwinds how would their current retirement look now?
Unfortunately, for today's young workers that imaginary world is their reality.
Fewer Defined Benefit Plans
The number of workers with a defined benefit plan, plans that pay workers a defined amount for their remaining life is decreasing rapidly. Participation in these plans declined from 38 percent in 1980 to 14% currently. To get the same benefit, workers will need to save more in their 401(k)s and manage it well.
Stock Market Price/Earnings Ratios
Since the early 80s, stock P/E ratios have slowly climbed from a low of near eight in 1992 to a high of over 40. Even after a big correction the Shiller P/E ratio currently is 24.5. This means, everything else equal, the relative price of stocks inflated roughly three times since the 1980s.
Will today's young savers also see an increase in P/E of three times? It is very unlikely. For that to happen the P/E ratio will need to move from 24.5 to an impressive 73.5 times earnings. Additionally, stock prices were eight times low earnings in 1982, now they are 24 times record earnings.
Unfortunately, most 401(k) plans are filled with investments that only perform well in bull markets when P/E is increasing. Stocks will always benefit from their ability to pay and retain earnings, but big significant gains in the stock market require the P/E to inflate, if it doesn't increase - stocks are just OK investments. If it deflates, they are a poor investment. The current P/E ratios built on record corporate earnings will present a headwind for today's savers.
Bonds are expensive
Bond prices in 1982 were relatively low and interest rates relatively high. Years of above-average inflation and Fed tightening had pushed up 10-year Treasury rates to over 15 percent, the equivalent of a price-earnings ratio of 6.7 times (100/15). Now, 10-year bonds are yielding about 2 percent - a price-to-interest ratio of 27.25 times.
This bond bull market paid out high interest and substantial appreciation for our current retirees. At such low interest rates, it is unlikely the future will be so kind to today's savers. There is little room left for bond appreciation and the low rates will conspire to slow the compounding of their retirement.
Housing prices show little room for appreciation
Housing can be another form of retirement savings. Many retirees downsize their house and use the proceeds to partially fund their retirement. Our 1980s retirement saver has seen their house price triple in the last 30 years. Owners who bought in 1975 are even more fortunate and have seen a fivefold increase. That's 500% or a little over 13 percent per year.
Housing prices have declined some recently. But, even with the recent decrease, without significant inflation, it is unlikely today's young saver's will see anything close to 13 percent per year appreciation on their home.
College debt blues
During the early 1980s, I earned my college tuition money from a summer job. This is nearly impossible now. Decreasing state support of higher education means significantly higher tuition payments for today's students even adjusted for inflation. The relatively higher payments translate into proportionately higher debt. As a result, the average college student now has about $26,600 in debt, according to the Project on Student Debt.
(University of Michigan)
At an interest rate of 6 percent, this translates to 10-year payback of approximately 285 dollars per month. That represents 285 dollars of "savings" they can't put toward their retirement. If the same amount was instead saved in an IRA at the same 6% rate the student would have amassed over $49,000 toward their retirement. Left, to compound to age 65 that 49,000 would grow to over 461,000 dollars at retirement. This is the lighter side of collecting interest versus paying it.
The burden of having to pay off student loans versus saving for retirement means losing time in the market. This will add one more headwind for future retirees.
In addition to the previous four headwinds, there is more. The current national political mood fosters discussing a decrease in Social Security benefits. There is talk of a higher retirement age or a recalculation of inflation adjustments. Neither side of the political spectrum is talking about increasing or expanding the benefits.
In addition to tough stock market valuations, low bond interest and appreciation, high housing prices and student loan debt, future retirees can also plan on a reduction in Social Security benefits.
There's some good news. Life expectancy is increasing, but it is mostly because more people are surviving to age 65. People who live to be 65 can't expect to live a lot longer than their ancestors but life expectancy at age 65 is moving up slowly. Today's retirees can expect to live a few years longer. Of course, this means they also have to fund a few more years of retirement.
It's Not Your Father's Retirement
When you add it all up, it points to a tough road for today's young workers and their investment planners. Relative large stock valuations, high bond prices and accompanying low interest rates, decreasing Social Security, a difficult housing market, few defined benefit plans, more student debt and longer lives will all conspire to make retirement saving more difficult. For today's young workers it will be very difficult to save and fund retirements in the future.
The Coming Crisis
I've covered several problems, but the engine that drives the well-being of today's retirees has been powered by four cylinders.
- Defined benefit pensions
- Equity and bond Bull Market driven 401(k)s
- Rapidly appreciating housing
- Social Security
If one or two of these cylinders were not working our engine it would be an inconvenience. But currently, none of these cylinders are firing for today's young workers and that is why we will have a crisis instead of simply a problem.
Preparing for tomorrow
For today's retirement savers success means a different course than taken by their parents. Unless these forces change, the vast majority of today's young workers will be poorer in their retirement years. The ones who seek to avoid it will need to look at a radically different, more aggressive path to retirement savings.
Higher savings rates - After paying their student debt, today's future retirees will need to save a much higher percent of their income. Getting there without a defined plan and these market headwinds may require annual deferments of 15%-20% or more into their 401(k), depending on the actual rate of return. This will, of course, be difficult if not impossible.
Safer investment management - They will need to be smarter safer investors. Without the backup of a defined benefit plan and the prospect of declining Social Security benefits they are at much higher risk. Unfortunately, a self-directed 401(k) plan is like driving a car without insurance. If you never wreck it you're way ahead, but if you have an accident your car is ruined. Much like a driver without insurance, today's investors will need to learn to manage their money safely.
Smarter investment management - The days of simply stuffing your money into a prepackaged stock or bond mutual fund may be over. Without a reasonable opportunity to expand the P/E ratio, or the tailwind of declining interest rates, these funds will have a difficult time producing the needed returns after expenses. Investors will have to look harder to find investments that will provide the needed risk reward ratio.
Until the national discussion changes from, how will we keep Social Security from going broke, to the more pressing need of how we keep today's workers from going broke in their retirement - there will be little relief.
Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.