There are a number of factors that we need to predict in order to come up with saving and investing strategies for retirement. The values that we assign to these factors will have a huge impact on whether or not we will be able to meet our goals. First, there is the expected return that investors will make on their retirement savings. Second, there is the common estimate that people will need about 85% of their pre-retirement income to support them once they stop working. Finally, there is the potential impact of behavior on savings rates, investing, and spending.
The Fidelity study cited earlier, for example, assumes that investors' portfolios will grow at 5.5% per year with no risk. How realistic is this? Ibbotson Associates, in making their projections, assume that the S&P 500 will deliver an average annual return of 10.96%, albeit with a fairly high level of risk (variability from year to year). The authors of the Fidelity study can reasonably argue that ignoring market risk and implicitly assuming the existence of a risk-free portfolio that yields 5.5% generates reasonable results and is justified on this basis. The Fidelity study comes up with a wealth accumulation target almost identical to that from Ibbotson, which did include market risk. Ibbotson's assumption of a 10.96% annual average return for the S&P 500 is optimistic when compared to estimates from a number of other experts. One well-known method to predict expected return for the stock market as a whole suggests that we should expect 5.6% per year from stocks. A recent analysis by Rob Arnott finds that the average annual return of stocks from 1871 through 2011 is 8.3% and that bonds have averaged 3.9%.
In estimating how much money people need to save and how much they need to accumulate in order to retire, however, we must make assumptions for expected stock and bonds returns and risks. Given the uncertainties in estimating these factors it is crucial that investors and advisors stress test portfolios to determine the range of outcomes if the future average returns from risky assets are lower than expected.
The estimate that people will need 75% to 85% of their working income when they are retired is often cited, but is also subject to huge questions. Lawrence Kotlikoff, a professor of economics at Boston University, is a determined critic of the use of target income replacement rates. Kotlikoff, and financial journalist and advisor Scott Burns, discussed their perspective on the income replacement rate in their 2008 book Spend Til The End, but a succinct summary of their thinking can be found here. Kotlikoff and Burns focus on estimating savings and income decisions on the basis of how you consume and save, with a goal of creating a constant standard of living through your life. From their perspective, the replacement rate is essentially meaningless because there are so many major variations between households. If, for example, you are making $100,000 a year and covering your living expenses with two kids at home and a mortgage that will be paid off when you retire, you are going to see a substantial decline in your cost of living when you retire. If you are a childless renter and you live on $100,000 now, your future needs will be much closer to your current income net of savings. If you want to come up with a reasonable estimate of how much income you will need in retirement, you need to add up your monthly costs and subtract those that will not be a factor once you retire. There is really only once source of costs that is likely to rise faster than inflation once you retire: healthcare. The main thrust of Kotlikoff's and Burns' argument is that simply using a single 'replacement rate' for all calculations is not a good idea, given how sensitive your estimated savings rate requirement will be to that one number.Moving Ahead
In writing this essay, my goal has been to summarize the key elements of saving and investing for retirement, without getting deeply into details. There is no question in my mind that the transition from traditional pensions to the current Defined Contribution model is, for groups of Americans, perhaps the most important economic event of the late 20th century. While there are many people trying to work through the implications of this economic shift, I believe that this topic deserves far more attention.
Only about half of Americans have any type of retirement plan at all. Among those who do have retirement plans, the average levels of savings are far below what most studies suggest are needed. Certainly having people working later in life can help to remedy low savings, but we are currently in an economic environment in which working longer is not necessarily an option. Furthermore, even if jobs are available, there is also high youth unemployment and putting older workers in competition with younger workers for scarce employment opportunities is unlikely to work out well for either group. At the very least, there will be broad societal implications if people simply work later in life. Not least of these is that there will be continued downward pressure on median household income from having fewer people leaving the workforce.
The most important step that investors can take to improve their retirement security is to save more, starting at as early an age as possible. People need to save 10% or more of their salaries. After saving, we need to invest in low-cost retirement plans so that expenses do not consume nearly as high a fraction of our savings as they do today. We need to hold portfolios that are well-diversified and maintain an appropriate level of risk. Finally, we must be disciplined in our investing and resist the urge to jump in and out of hot stocks or funds. Performance chasing has historically been very expensive. The good news is that it is possible to do all of these things with a minimum of effort. Well-designed target date strategies provide an easy way to hold a diversified portfolio and most target date strategies maintain risk levels within a reasonable range. I hope that we will see more standardization in the risk management and risk control processes for target date strategies in the future.
Saving more and seeking out simple low-cost investing solutions requires real effort. I have heard it said that financial planning is "simple but not easy." Just as eating a healthy diet and exercising are crucial to our long-term physical health, saving and investing are crucial to our long-term financial health. As a nation, we do not want to see what happens with an aging population that has saved far too little to sustain a decent standard of living in retirement. The technological solutions are in place to enable low-cost diversified investing. The next step is that we must fully commit to using these innovations to our advantage.Related Links:
- Saving and Investing for Retirement: Part Four
- Saving and Investing for Retirement: Part Three
- Saving and Investing for Retirement: Part Two
- Saving and Investing for Retirement: Part One
Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.