There are many variables that can have a large impact on a person's retirement plan. Today I want to take a look at two competing ideas and problems for most of us when it comes to securing our own retirement. I'm going to look at how big of an impact the following two variables have on a retirement plan: how much is saved each year vs. total returns on investments.
I ran several scenarios for a 45 year old couple in our retirement planner. Here were my assumptions:
Current Age of Both People
Social Security at age 67 (combined, today's $)
$30,000 per year
Average Savings Rate
8% on Total Income of $100,000
Total Investment Balance Today (50% in taxable accounts, 50% in IRAs)
Recurring Annual Expenses in Retirement
70% Equities 30% Treasuries
Return Assumption Equities
6% per year
Return Assumption Treasuries
1% per year
The first thing I want to analyze is how this couple's retirement situation changes as they save various amounts of money each year. The results are presented below-
Age When Funds Run Out
We can see in the base case that this couple will run out of money at age 89. We can also see that they can extend their funds in retirement substantially if they increase their savings rate enough. How does this compare with total returns on their investments changing over time? I ran some scenarios where total returns are shocked up and down. The results are below-
Change in Total Returns
Age When Funds Run Out
Never (Age 130)
To some, the results above might be surprising. If the total returns on this couple's investments simply fall by 2% per year, they will run out of money 12 years earlier than the base case. If returns are 2% higher, they will never run out of money as the funds would be extended all the way through age 130.
It is quite obvious that changes in total returns have a much more significant impact on a person's retirement plan than how much they save. But the results also tell us something else: Those who are using a total return assumption for equities of 8% to 10% per year could be in serious trouble if returns are lower. By assuming higher returns, many people will save less each year because they expect equity returns over time to make up the difference. It lulls them into complacency. I believe it is best to be conservative with return assumptions, especially for equities in today's world.
The results also tell us that one way to retire earlier is to generate returns that not only beat inflation, but provide serious compounding over time. My strategy is to invest in a portfolio of solid dividend paying stocks with a history of consistent dividend growth, such as Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), Exxon (NYSE:XOM), and Wal-Mart (NYSE:WMT). These companies have provided a solid and growing stream of dividends for decades and are perfect for retirement portfolios where the dividends can compound over time.
5 Year Annualized Div Growth Rate
My belief is that it is prudent to be conservative with return assumptions and save as much as possible today. I am also a strong believer in dividend paying companies who have shown a culture of raising dividends over time, even during economic downturns.