Intermediate Savings Goals Prior to Retirement White Paper on Retirement, November 2014 Richard C Marston, Wharton School

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1 Intermediate Savings Goals Prior to Retirement White Paper on Retirement, November 2014 Richard C Marston, Wharton School Saving for retirement is tough for young and old alike. Most of us know how important it is to save for retirement since Social Security replaces only a fraction of our income in retirement. But saving is so hard to do. In Investing for a Lifetime, I frame the savings task in terms of a savings goal enough wealth to live as comfortably in retirement as in our working years. The savings goal is expressed as a multiple of income. That is, we must save X times our income by the time we retire. As I showed in the book, a single investor earning $100,000 prior to retirement must save almost 15 times this income prior to retirement. The savings goals set out in the book are so formidable that I worry readers will feel overwhelmed by the task ahead. This paper addresses the issue by breaking the long run savings goal into intermediate steps. 1 I ask what percentage of the goal must be reached by the time the investor is 45 or 50 or 55. The answer to this question is much more encouraging. As with many of life s formidable tasks, when broken down into smaller chunks, the impossible becomes possible. That is simply because investment returns compound over time, so intermediate savings goals are not as high as you might think. For example, most investors need reach only about one half of their goal by the age of 55 That is, investors ten years from retiring need only have saved about 50% of their retirement savings goal by the end of their 55 th year. Investors who are twenty years from retirement need to have reached less than 20% of their retirement goal. These results suggest that retirement savings is much more manageable than it might seem at first. A cautionary word, however: These results obviously depend on when savings begin. (If we begin at the age of 54, it might be a little difficult to reach any savings goal, intermediate or not). And they also depend on when investors intend to retire. But they hold for a variety of investors who intend to retire at the full retirement age (FRA) of 66. SAVINGS GOALS FOR YOUNGER AND OLDER INVESTORS PERCENTAGE GOALS In Investing for a Lifetime, I focus considerable attention on investors who make $100,000 per year in real terms throughout most of their careers. For investors with that level of income, Social Security is a major source of income in retirement. Social Security payments of course depend on when the investor retires. In Chapter 4 of the book, I report that Social Security benefits for a single individual retiring at the full retirement age (FRA) of 66 were $26,000 as of A married couple eligible for the maximum spousal benefit of 50% of the Intermediate Savings Goals Page 1

2 wage earner s income would receive $39,000 per year. 2 the savings goals for single or married investors. Those payments substantially reduce What else does the savings goal depend upon? Two factors are most important: (1) The spending rule in retirement. In my book, I assume that retirees can spend 4% of the accumulated wealth excluding housing. This 4% rule is conventional in retirement planning. But in a world where a New Normal of lower returns may lie ahead, a 4% spending rule may be too high. The effects of lower future returns are discussed later in this paper. (2) The savings goal also depends on what percent of pre retirement income must be replaced. In my book I assume 85%. The rationale is that in retirement, investors don t have to save anymore. If they have saved 15% of income prior to retirement, they can maintain their pre retirement spending with only 85% of their earlier income. If the investor plans to spend 4% of wealth in retirement and aims to replace 85% of a $100,000 income, then the savings goal is easy to calculate. Let s begin with the investor who is single. To reach the goal of in retirement, that investor must generate $59,000 from the portfolio since he or she is already assured of earning $26,000 in Social Security payments. If the spending rule is 4% of wealth, then it easy to calculate how much savings the individual must accumulate to generate $59,000 per year. That s $1.475 million. 3 What a formidable task! For this investor, the savings goal is times income. If a married couple is involved, the task is a little easier. Specifically, if this couple is eligible for the maximum spousal benefit, the $39,000 in Social Security payments means that they need only generate $46,000 from their portfolio. To fund this large a withdrawal, the couple must save a total of $1.15 million by the time of retirement. So the savings goal for married couple making $100,000 is 11.5 times income. Table 1 below (which reproduces Table 4.1 in my book) summarizes these calculations. Table 1 Savings Goal Required to Replace Pre Retirement Spending Individual Social Security benefits $26,000 Withdrawal from portfolio $59,000 TOTAL Percent of income replaced 85% Couple $39,000 $46,000 85% Required Wealth at retirement Savings goal $1,475, $1,150, Assumptions: Retiree earned $100,000 prior to retirement. Retirement is at age 66 so the retiree has reached full retirement age. Savings goal is adjusted to ensure that postretirement spending is equal to 85% of pre retirement income. Withdrawals are based on a 4% spending rule. Intermediate Savings Goals Page 2

3 These savings goals are so formidable that they may scare away many readers. So I thought that it was important to show that these same goals are less formidable when seen from the perspective of a 45 year old or a 55 year old. Investors don t need to have saved nearly as much by the time they are 55 (ten years from retirement) or 50 or 45. For example, only about half of the savings goal needs to be reached by the age of 55. How much an investor accumulates over time obviously depends on the rate of return on investment. Since what matters is the accumulation of wealth in real terms net of inflation, the rates of return also have to be measured in real terms. In Investing for a Lifetime, I assume that returns on stocks and bonds are equal to their long run historical averages of 6.5% for equity and 2.5% for bonds. These are approximately equal to the average real returns earned over the last 63 years (since 1951) and over the last 88 years (since 1926). If the investor has a portfolio weighted 75% in stocks and 25% in bonds, the average real return is going to be about 5.5%. Since we are interested in intermediate savings goals for those nearing retirement as well as those far from retirement, it s important to discuss how the asset allocation varies as the investor gets closer to retirement. I assume that the 75% allocation to stocks remains intact until the investor is 15 years from retirement (or 50 years of age for someone retiring at the end of the 65 th year). Then the allocation to bonds is steadily increased until it reaches 50% at retirement. Figure 1 shows the percentage of the portfolio invested in bonds from the age of 36 until retirement. At retirement, the 50/50 stock/bond portfolio should have a real return of 4.5%. In a later section, I will show how the savings process changes if future real returns on bonds and stocks are lower than in the past. Intermediate Savings Goals Page 3

4 To see how savings goals change as the investor gets closer to retirement, consider the individual investor described above. Individuals must save as much as $1.475 million by the end of their 65 th year in order to meet their retirement goals. But 10 years earlier, at the age of 55, they need only save a little over one half as much as shown in Table 2 below. By the age of 50, they need save only 33% of their goal, and by the age of 45, they need save only 19.0%. This makes the huge task of saving for retirement a little less formidable even if not quite bite size. The reason why the percentages are so low 10 or 15 years earlier is because of the magic of compounding. The wealth accumulated by the age of 55 will benefit from compounding for the next ten years. Those who have already reached 51.1% of their savings goal by the age of 55 will reach 100% of their goal on time at the end of their 65 th year. Table 2 Savings Goals by Age of Investor Individual Investor Wealth at Retirement: $1,475,000 Savings rate: 21.8% Age at end of year Notes: same as Table 1. Wealth in $ (thousands) $121.7 $280.7 $488.5 $753.5 $1,080.3 $1,475.0 As % of Wealth at Retirement 8.2% 19.0% 33.1% 51.1% 73.2% Married Couple Wealth at Retirement: $1,150,000 Savings rate: 17.0% Wealth in $ (thousands) $94.9 $218.9 $380.9 $587.6 $842.4 $1,150.0 As % of Wealth at Retirement 8.2% 19.0% 33.1% 51.1% 73.2% What about the married couple described above? As shown in Table 1, the couple only has to save $1.15 million by the time of retirement. To reach that goal, the couple can have a lower savings rate than the individual investor. The required savings rate of 21.8% of income for the individual is replaced by a 17.0% savings rate for the married couple. But as shown in Table 2, savings need reach only 51.1% of the goal when the investor is 55, just like the individual investor. In the case of the couple, that means saving $587.6 thousand by the age of 55. The reason why the percentage savings goals are the same for the individual investor and married couple is that these percentages depend only on the rate of return, not on the retirement savings goal in dollar terms. Before considering what factors might alter the percentage goals, consider also the case of investors who earn more or less than the investors in Table 2. In Table 4.2 of Investing for a Lifetime, I showed how retirement savings goals vary a lot by income level for married couples. A couple who makes $50,000 per year must save only 8.5 times their income, whereas a couple making $200,000 per year must save 15.5 times their income. Despite having such a wide range of dollar savings goals, investors at all these levels of income have the same percentage Intermediate Savings Goals Page 4

5 goals as those reported in Table 2. For example, investors earning $200,000 have to save a much larger dollar amount by age 55, but they need reach only 51.1% of their retirement goal of $3.1 million by the time they reach retirement. HOW EARLY RETIREMENT AFFECTS SAVINGS GOALS Table 2 seems too good to be true. The natural question to ask: what would undermine these results? In a later section I will show that lower returns do require higher intermediate goals, but less than you might imagine. What matters much more is the age when retirement occurs. Readers of my book should not be surprised to see that retiring early has its costs. (See Chapter 18). Current Social Security law allows investors to retire as early as 62 years of age. Those investors electing to retire at 62 must have much higher wealth accumulated by the time they retire to sustain the same lifestyle in retirement as those retiring at the full retirement age of 66. And they must save at a much faster rate to achieve that level of wealth. Their intermediate savings goals, moreover, must be much more aggressive than those who intend to retire at 66. To see how savings are affected by early retirement, first consider the Social Security payments available to a married couple that elects to retire at 62 rather than 66. A worker retiring four years early receives 25% lower SS benefits. But the maximum spousal benefit is also cut to 35% of the worker s pay rather than 50%. The net result is that SS benefits are cut to $28,600 from $39,000 (using 2013 SS rates as in Table 1). 4 To reach the goal of spending per year in retirement, the couple must accumulate $1,410,000, a 22.6% increase over the savings goal of someone retiring at 66. On the other hand, a couple retiring at 70 must accumulate $942,500 rather than $1.15 million to match preretirement spending. Table 3 Savings Goals by Retirement Age Retirement age SS Benefits Withdrawal from Portfolio TOTAL $28,600 $56,400 $39,000 $46,000 $47,300 $37,700 Wealth Required at Retirement $1,410,000 $1,150,000 $942,500 Assumptions: Married couple with full Social Security spousal benefits with earnings of $100,000 prior to retirement. Savings goal is adjusted to ensure that post retirement spending is equal to 85% of pre retirement income. Withdrawals are based on a 4% spending rule. How does the couple retiring early accumulate that much wealth, especially since there are four less years to save? The answer is that the savings rate must be much higher. A couple retiring at 62 must save 27.4% of their income (rather than 17.0%) to achieve their savings goal! As explained in Investing for a Lifetime, retiring early not only reduces Social Security payments Intermediate Savings Goals Page 5

6 by a substantial amount, but it also forces the retiree to start drawing from the portfolio rather than allowing returns to compound unimpeded for another four years. Those who plan to retire early probably know that they must save more than those retiring at 66. But most of them are probably unaware that they must save 10% more of their income per year during their working years to gain these four extra years of retirement. What about intermediate savings goals? The decision to retire early increases the required savings at the age of 55 from 51.1% of the retirement savings goal to 66.1% of that goal. And at 50, the couple should have accumulated 43.3% rather than only 33.1% of their goal. It s clear from this table early retirement puts a huge extra burden on retirement savings from the very beginning of the savings process. Everything about the savings process is harder: the retirement savings goal is much higher and so is the required savings rate. And at each age milepost, the goals are much higher than they would be otherwise. Table 4 Intermediate Savings Goals by Age of Retirement Retirement age 62 Required Savings Rate 27.4% Age of Investor at end of year % % % % % Assumptions: Same as Table % 8.3% 19.0% 33.1% 51.1% 73.3% 78.2% % 6.4% 14.7% 25.6% 39.7% 57.6% 61.7% 79.5% As in the book, I should hasten to add that the decision to retire early is often driven by factors unrelated to the savings decision such as the type of work undertaken and the industry in which the worker is employed. Many people in their early 60s are forced to retire from their life long job. Others retire for health reasons. This paper is aimed at readers who have a choice about when they retire. For those readers, early retirement may have many benefits, but this paper documents some of the evident costs. HOW LOWER RETURNS AFFECT SAVINGS GOALS Intermediate savings goals also depend on the rate of return on the portfolio. We might have to save much more if future returns are lower than they have been in the past. How might the intermediate savings goals outlined above be affected if the New Normal undermines future returns? Intermediate Savings Goals Page 6

7 How much lower might future returns prove to be? Over short periods of time, stock returns can be disastrously low at times. And even over a period as long as a decade, stock returns can be much lower than in the long run. That was true in the 1970s, for example. But over a working lifetime of thirty or forty years, there is likely to be much less variability in average returns than over shorter periods. So I will consider long run real returns that are 20% or 40% lower than historical averages. That should be depressing enough for most readers. Let s consider the case of a married couple retiring at the full retirement age of 66. If returns are 20% or 40% lower, there is one major change in the savings requirements of this couple. If returns are that much lower, they must save at a faster rate to make up for the lower returns. Instead of saving 17.0% of their income, these investors must save 20.2% if returns are 20% lower. And if returns are 40% lower, or 3.3% per annum rather than 5.5% per annum (when 75% of the portfolio is invested in stocks), then savings must rise to 24.0% of income. These results just show how important compounding of investment returns can be. If the New Normal prevails, younger investors are going to have to increase their savings quite significantly. Yet intermediate savings goals do not change that much if returns are lower. If historical returns prevail, then as shown above the couple must reach about 51.1% of their savings goal by the age of 55 and 33.1% by the age of 50. Suppose that returns are 20% lower in the future. At 55 years of age, the investors must have saved 54.1% of their goal rather than 51.1%. And at age 50, the investors must have saved 36.2% of their retirement savings goal rather than only 33.1%. These goals are no doubt tougher to achieve, but lower returns have much less impact on intermediate savings goals than does retiring at 62 rather than 66. Table 5 Savings Goals by Age of Investor Lower Rates of Return Rate of Return (until age 50) 5.5% 4.4% (20% lower) 20.2% 3.3% (40% lower) 24.0% Savings rate 17.0% Age of Investor at end of year % 9.6% 11.1% % 21.5% 24.3% % 36.2% 39.7% % 54.1% 57.5% % 75.3% 77.7% 65 Notes: Same as Table 1 for the case of the married couple who retires at 66. Note that returns are lower than stated above when the proportion invested in bonds increases after age 50. The savings rates in Table 5 are based on the assumption that the couple can spend 4% in retirement. But if investment returns are lower during retirement, then the 4% rule might have to be modified downward. A lower spending rule would require a higher savings goal at retirement as well as a higher savings rate. But note that the percentages of the savings goal that must be achieved by age 55 or earlier remains the same as in Table 5. Intermediate Savings Goals Page 7

8 Table 5 assumes that returns are constant throughout the savings period. If returns are lower early in the savings process, this makes savings goals more difficult to achieve. This was certainly true in my own career because I started saving for retirement in the 1970s when returns on both stocks and bonds (in real terms) were abysmally low. Even if we were confident that we would face the same average real returns in the future as in the past, we would still face uncertainty about the timing of returns. So what is an investor to do in order to reduce uncertainties about average returns and the timing of those returns? The answer is to err on the side of caution by starting the savings process as early as possible. In Investing for a Lifetime, I show how much easier it is to reach retirement savings goals if investors start five years earlier at 31 or ten years earlier at 26. Though I stress how hard it is for some individuals to start savings in their 20s or early 30s because of college indebtedness or the inability to land a good job immediately, early savings make a big difference. For example, if a married couple starts saving at 31 rather than 36, they need to save only 12.9% of income rather than 17.0% to reach savings goals. That s despite the fact that I assume they are paid 25% less at 31 than at 36. If the couple starts saving at the age of 26 (when income is assumed to be only half of the long run level, or $50,000), the savings rate need only be 10.5% of income throughout their working years. So starting early makes a huge difference because investment returns compound over time. CONCLUDING REMARKS As I stated in the preface of my book, saving is much harder than investing. Too many baby boomers are approaching retirement without sufficient savings. Savings goals just seem too formidable. This paper focuses on the intermediate goals that investors must reach at earlier ages. I hope that these intermediate goals will make the task ahead seem more manageable. REFERENCES Farrell, Charles, 2010, Your Money Ratios: 8 Simple Tools for Financial Security at Every Stage of Life, Avery Press. 1 I would like to thank Walter Updegrave, long time columnist for Money Magazine, for suggesting that I break up the savings goals in Investing for a Lifetime into intermediate steps. In his book, Your Money Ratios: 8 Simple Tools for Financial Security at Every Stage of Life, Charles Farrell had earlier discussed intermediate savings goals framed as capital to income ratios. 2 In Chapter 18 of Investing for a Lifetime, I discuss how Social Security payments are lower if both spouses both work but earn the same total income as the married couple in Tables 1 and 2. 3 That is, $1.475 million * 4% = $59,000. Intermediate Savings Goals Page 8

9 4 For further discussion, see Chapter 18 of Investment for a Lifetime. Unlike Table 18.4 in the book, Table 3 calculates wealth at retirement sufficiently large to fund 85% of preretirement income. Intermediate Savings Goals Page 9

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