It s Time to Save for Retirement. The Benefit of Saving Early and the Cost of Delay

Transcription

1 It s Time to Save for Retirement The Benefit of Saving Early and the Cost of Delay November 2014

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3 About the Insured Retirement Institute: The Insured Retirement Institute (IRI) is the leading association for the retirement income industry. IRI proudly leads a national consumer coalition of more than 30 organizations, and is the only association that represents the entire supply chain of insured retirement strategies. IRI members are the major insurers, asset managers, broker-dealers/distributors, and 150,000 financial professionals. As a not-for-profit organization, IRI provides an objective forum for communication and education, and advocates for the sustainable retirement solutions Americans need to help achieve a secure and dignified retirement. Learn more at IRI All rights reserved. No part of this book may be reprinted or reproduced in any form or used for any purpose other than educational without the express written consent of IRI.

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5 OVERVIEW Albert Einstein is reputed to have said, Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn t, pays it. This statement is particular true with regard to the accumulation of retirement savings, where starting early means saving a far more manageable percentage of income than starting later in life. This paper uses real-world income and retirement plan contribution averages as well as reasonable investment return and inflation assumptions to demonstrate the impact on potential lifetime income of starting to save for retirement in each year of working life, from age 30 to age 60, and conversely the percentage of income that would need to be saved in each working year, beginning at each of these ages, to achieve the same potential lifetime income as someone who began saving earlier. The paper will further show how critical this savings behavior is in terms of projected income need, based on 30 years of data on the spending habits of individuals in retirement. KEY FINDINGS AND ANALYSIS The retirement savings window, the period of time over which one can realistically expect to save for retirement, has shortened considerably as young Americans enter the workforce later and thus begin contributing to retirement plans at older ages. The average age at which young workers reach the median wage has increased from 26 to 30 since A worker with annual income of $42,000, approximately the median wage and a level of income associated with financial independence 2, and saving 7% of income plus a 3% matching contribution, beginning at age 30 in a 401(k) or other defined contribution plan may be able to generate lifetime income of $22,467 in today s dollars from the plan account balance at age 65. The same worker waiting until age 70 would be able to generate $38,829 in annual income in today s dollars, due to the additional 5 years of contributions and investment earnings, 72.8% higher than if income began at age 65. At a 12% savings rate plus 3% match, potential income at age 65 in today s dollars would be $33,700; at age 70 it would be $58,244. A worker putting off saving until age 35 would need to save more than 16% of income annually to produce the same potential retirement income at age 65 as someone who started saving at the 10% rate beginning at age 30; starting at age 40 would require saving more than 26% of income. It s Time to Save for Retirement: The Benefit of Saving Early and the Cost of Delay 1

6 THE POWER OF STARTING TO SAVE AT YOUNGER AGES One of the most powerful retirement planning decisions a younger worker can make is to contribute as much as possible, at as young an age as possible, to a retirement plan such as a 401(k). Contributing over a longer period of time increases the total amount contributed and maximizes the compounding of investment earnings and interest. The two charts below illustrate how potential retirement income is impacted by delaying contributions to a 401(k) or other deferred contribution retirement plan. The charts are based on the following assumptions: Annual income at age 30 of $42,000 Annual income increases at 3% annually Annual retirement plan employee contribution rates of 7% and 12% of income Employer match equal to 3% of annual income 7% annualized investment return Future plan balance discounted at 3% to express lifetime income in today s dollars $66.00 in annual lifetime income at age 65 per $1,000 of discounted plan balance; $76.80 per $1,000 at age 70 3 PRESENT VALUE OF ANNUAL INCOME AT AGES 65 AND 70 VS. RETIREMENT SAVING START AGE 10% SAVINGS RATE (7% EMPLOYEE DEFERRAL PLUS 3% EMPLOYER MATCH) 2 Insured Retirement Institute

7 PRESENT VALUE OF ANNUAL INCOME AT AGES 65 AND 70 VS. RETIREMENT SAVING START AGE 15% SAVINGS RATE (12% EMPLOYEE DEFERRAL PLUS 3% EMPLOYER MATCH) In the early years, for each year that the decision to begin saving is delayed, potential annual lifetime retirement income is reduced by 2% to 3%. Later, as the impact of foregone years of compounding investment returns becomes more significant, the early saver is even more advantaged as the reduction in potential income becomes steeper. The cumulative effect is quite significant; a worker who begins saving 10% of his or her income at age 35 would realize, under these assumptions, annual lifetime retirement income of $19,992 versus $22,467 if saving begins at age 30, over 11% less per year and $62,000 less over a 25-year retirement. If saving is delayed until age 40 potential income is reduced by almost 23%, or a reduction in total income realized of over $127,000. Delaying retirement until age 70 can lessen the impact of delayed saving in absolute terms, due to the additional contributions and the time investment earnings can compound, and the calculation of lifetime income payments beginning at an older age. Saving 10% of income beginning at age 30 produces potential annual lifetime income at age 70 of almost $39,000 in today s dollars, compared to about $35,000 if saving begins at age 35, or about 7.6% lower income per year. When saving begins at age 40 potential income drops to about $31,000 annually, over 19% less than the 30-year-old saver can expect. While delaying retirement until age 70 offsets some of the impact of beginning to save later, it may not be possible or feasible. Health status may prevent some people from working, and others may simply not have the opportunity to do so. Starting to save early, when one is in peak health and earning years, is a far more effective retirement strategy and helps mitigate the risk that retirement may occur earlier than planned. It s Time to Save for Retirement: The Benefit of Saving Early and the Cost of Delay 3

8 THE OTHER SIDE OF THE COIN: THE COST OF PLAYING CATCH-UP The effect on the potential amount of lifetime retirement income a worker may be able to produce from a defined contribution retirement plan is one lens we can look through to measure the cost of delaying saving for retirement. Another and perhaps more effective way to demonstrate the impact of starting to save later in one s career is to calculate the amount that would need to be deferred at older ages to produce the same potential lifetime income as can be calculated for someone who begins saving at age 30. As the following charts reveal, the percentage of income that a worker would need to contribute to a retirement plan increases each year and surpasses a contribution level that most people would consider realistic at a fairly young age. The end result is, within the bounds of these calculations, at a certain point it is very unlikely that an older individual can catch up to the younger saver. REQUIRED SALARY DEFERRAL WHEN SAVING BEGINS AFTER AGE 30 BASELINE: 7% EMPLOYEE DEFERRAL, 3% EMPLOYER MATCH BEGINNING AGE 30 4 Insured Retirement Institute

9 REQUIRED SALARY DEFERRAL WHEN SAVING BEGINS AFTER AGE 30 BASELINE: 12% EMPLOYEE DEFERRAL, 3% EMPLOYER MATCH BEGINNING AGE 30 Based on the assumptions used in these calculations, a worker planning to retire at age 65 and beginning to save for retirement at age 35 would need to contribute 16.5% of annual income in order to end up with the same amount of lifetime income at age 65 as an employee contributing 10% of income to a retirement plan beginning at age 30. To attain that level of retirement income when beginning to save for retirement at 40 years of age, that worker would need to contribute over 26% of annual income, a level that from a practical standpoint would likely be unfeasible. The failure to begin to save early is, for most, an irretrievably missed opportunity in terms of potential accumulation. Whether one is ahead of or behind the savings curve, however, understanding the potential of accumulated retirement savings to generate sustainable lifetime income is critical to planning for an adequate standard of living in retirement. THE POWER OF ILLUMINATION AND PLANNING Calculating the lifetime retirement income that a defined contribution retirement plan balance can be expected to produce at retirement age is an important step in understanding how plan contributions, and the time horizon over which those contributions are made, impact that potential income. Using retirement income calculators, such as those available to all consumers at enables workers to change various inputs in order to determine how to optimize their savings behavior. For example, one may find through use of a calculator that withdrawals from a retirement plan beginning at age 65 may only be projected to last until age 75 or 80. A younger worker armed with retirement income projections may choose to increase contributions, resulting in a higher probability that accumulated retirement savings will produce a sufficient level of lifetime retirement income. An older worker might both increase contributions and also begin planning to retire later, if possible, increasing the time horizon for contributions and investment returns to accumulate. Consulting a financial advisor for assistance in planning for retirement is another positive step workers can take to increase their probabilities of success; IRI research on the retirement readiness of Generation-X showed that while only two-thirds of GenXers have money saved for retirement, the median amount saved for retirement by those who work with a financial planner is twice the amount saved by GenXers who do not work with a financial planner. This is not surprising when one considers that, as a group, GenXers generally lack knowledge about financial matters, with only 30% rating themselves highly knowledgeable. With these findings in mind, the need for retirement planning and retirement investment education is manifest. 4 It s Time to Save for Retirement: The Benefit of Saving Early and the Cost of Delay 5

10 INVESTMENT RETURNS AND RETIREMENT INCOME This paper began with a quote from Albert Einstein extolling the virtues of compound interest. Unfortunately, most projections of future account balances, including those used in this paper, are based on investment return assumptions that, while reasonable from a historical average perspective, include a presumption of the use of risk assets, the investment returns of which may be negative in some periods, can be volatile, and do not truly compound the way an interest bearing security or savings account does. Longer investment horizons for accumulating retirement assets can help mitigate these effects, however, as contributions are made and investment returns accumulated through many market cycles. Asset allocation helps offset this risk as well; research has shown that the average annualized return over the period from 1926 through 2009 of a 50% stock/50% bond portfolio during recessions was 7.75%, compared to 9.90% during expansionary periods. 5 SPENDING IN RETIREMENT A LOT CAN CHANGE IN 30 YEARS According to data from the Bureau of Labor Statistics, in 1984 the average annual expenditures of someone in the 65 to 74 age group totaled $15,842. By 2013 that figure had risen to $46,757, a 3.8% annualized increase. 6 By contrast, CPI Inflation over the same period was 2.82%. 7 While the basket of goods and services in each category of expenditures is not necessarily constant over such a long period of time, the fact remains that spending in retirement has accelerated faster than the inflation rate, therefore data on actual expenditure increases may be a better barometer than expected inflation for gauging income needs in retirement. Taking this a step further, we can use the expenditure data to project expenses forward, and then calculate the present value of those expected expenses at a conservative 4% return rate to approximate the retirement plan balance needed to fund 40 years of expenditures. PRESENT VALUE OF RETIREMENT EXPENDITURES As the chart shows, the present value of expected expenditures has increased dramatically in the past 30 years, from about $300,000 in 1984 to over $700,000 in The BLS data on expenditures does show that expenditures tend to decrease after age 75, but in light of expected future health care costs it is prudent to assume that reductions in spending for expenditure categories such as leisure and entertainment will be replaced by increased medical expenses. 8 In contrast, the present value of Social Security benefits in 2013 was less than $400,000. This implies that retirees will need significant assets at the point of retirement, and will need to efficiently utilize those assets to generate enough income to fill the income-expenditure gap. 6 Insured Retirement Institute

11 CONCLUSION It is critical for workers to begin saving for retirement early, and at a level that maximizes the probability of accumulating sufficient retirement plan assets to fund expenditures in retirement. Late savers are significantly disadvantaged, both in terms of shorter time horizons over which plan contributions can be made and from the standpoint of market cycles and investment returns. There is compelling statistical evidence to suggest that the present value of expected future expenditures for the average worker at the point of retirement far exceeds the present value of Social Security, leaving the responsibility for funding those expenditures to the individual. Expense reduction, income producing securities, asset allocation, and annuities are all tools that can be brought to bear at the point of retirement to manage the income-expenditure gap, but the earlier planning and retirement saving begin, the more flexibility the individual will have to employ those tools. FOOTNOTES 1. Georgetown University Center on Education and the Workforce Analysis of March Current Population Survey, 1980, Georgetown University Center on Education and the Workforce Analysis of March Current Population Survey, 1980, 2012, CPS Utilities, Unicon Research Corp. 3. ImmediateAnnuities.com annuity calculator 4. IRI The Retirement Readiness of Generation X: The Lasting Effects of the Great Recession on Gen-Xers Retirement Outlook January, Vanguard Report, Recessions and Balanced Portfolio Returns October, Bureau of Labor Statistics, Consumer Expenditure Survey 1984, CPI Inflation Calculator 8. IRI Planning for Health Care: How Excellent Health and Longevity Impact Retirement Income Planning September, 2014 It s Time to Save for Retirement: The Benefit of Saving Early and the Cost of Delay 7

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