Our children and grandchildren are urged to save and invest for retirement. Their success depends on saving regularly and investing well. Success also depends on how long they work, how much they save, and how successful they are in their careers. Today we look at those three elements.
I have been working on a financial model of retirement savings to learn the principal drivers of successful retirement accumulation.
Here are the main results
- Workers who start a career now, work 40 years and expect only cost-of-living raises, will find a 10% saving rate is more than adequate for retirement. At low starting incomes, say $20,000 per year, saving 4% per year will do. At high starting incomes, $60,000, saving 6.2% per year will do. Put another way, saving 10% per year will prepare a worker for retirement in 25 to 31 years. The key is that they earn only cost-of-living raises—their real incomes stay constant.
- More ambitious, perhaps typical workers will earn raises exceeding the cost of living. Workers earning 2% per year above the cost of living will need to save 10% per year or more to provide for retirement. Workers at low starting incomes ($20,000) can save 10% and have an adequate retirement. But workers starting at $60,000 per year will need to save 12% per year to achieve an adequate retirement in 40 years. Workers starting at $90,000 per year will need to save 13% per year.
- Very successful workers who earn 4% per year above the cost of living will have the hardest time saving for retirement. Workers starting at a low income ($20,000) can achieve a good retirement by saving 16% per year of their incomes, but workers starting at high incomes ($60,000 to $90,000) will need to save 20% to 21% per year.
- Time matters. For a typical worker (starting at $40,000 per year and earning raises 2% per year above the cost of living), saving 10% each year for 40 years instead of 30 years, nearly doubles the amount of accumulation, from $505,000 at 30 years to $1,000,000 at 40 years. That’s true even though the portfolio shifts in the model from 80% stocks at 30 years to 60% stocks for the last 10 years before retirement.
What’s going on in the model
An individual is assumed to work 40 years, say from her mid twenties through her mid sixties, then retire. At retirement she will be entitled to a Social Security benefit, and she will have accumulated investments in stocks and bonds from saving during her career. She does not have a traditional pension, though the model can include one.
The model includes Social Security benefits as a function of final income, as well as varying levels of annual savings and investment returns.
An adequate retirement is defined as one in which an individual retiree can receive the same disposable income in retirement that she had at the end of her career. That definition is key: very successful workers earning significant raises must save huge amounts of money to keep that final living standard going.
Since Social Security benefits are fixed in law, workers need to forecast how much to save in order to replace the part of their disposable income not covered by Social Security. That is where the model helps.
In retirement, payroll deductions for taxes, insurance, and perhaps charities will usually decline. I’ve estimated that decline to be 15% of gross income. A retirement income that is 85% of a preretirement income will offer the same after-tax income. Also, retirement savings itself stops at retirement. That savings, too, must be subtracted from preretirement income.
Therefore, a person who saves 5% to 10% every year for retirement needs only 80% to 75% of her preretirement income to stay even. That final amount is the retirement income goal, which can be met from two sources: Social Security and a retirement portfolio. Once Social Security benefits are subtracted, the rest must come from portfolio withdrawals.
We already know from the 4% rule, that whatever amount of the needed annual withdrawal, it can be achieved easily if the retiree has saved 25 times that amount. It can also be achieved by buying an annuity, and in that case, given today’s annuities markets, a person needs to save about 15 times the needed annual withdrawal. The results reported above are based on the 4% rule, not on the annuity.
There are a couple of small ironies. First, the higher a persons starting and final incomes, the harder it is to achieve adequate retirement savings. That’s because Social Security is progressive—at higher incomes, it replaces smaller percentages of a worker’s preretirement income.
Second, and more important, the more success and consequent income increases a person achieves in her career, the harder it is to prepare adequately for retirement. The reasoning is more subtle, but basically it is because the early career savings are based on smaller incomes, and their compound growth never catches the salary increases and the consequent need for even greater accumulations as retirement approaches.
These are not easy concepts to grasp, and I may be foolish to treat them in a blog like this. But I wanted to learn what savings would be necessary, in the absence of a traditional pension, to achieve an adequate retirement.
Writers often recommend annual savings of 10%, 15%, or 20%, without explaining any determinants. Here we’ve seen that the saving effort will vary dramatically depending on initial income and career success.
I’ll be happy to discuss more details with any interested readers, including doing simulations to their specifications. The model can incorporate varying investment returns, career lengths, saving disciplines, matching employer contributions, help from parents, as well as other definitions of “adequate retirement.”
Workers with moderate financial success—perhaps nurses who stay in patient care, secretaries who stay in their jobs or other service workers who stick to the trenches—need only a modest saving effort. Any employer matches will make that need smaller. Saving up to 10% per year may not be easy, but it is doable.
Workers who are very successful and earn significant increases in real incomes have a much harder time accumulating enough to provide an “adequate retirement.” Saving 20% per year of a beginning salary during the early years of a career is difficult and not often done. These workers should probably redefine “adequate retirement.” Instead of aiming to replace their final salary, they will find it much easier to replace the income they had in mid-career, 10 or 15 years before retirement. That is still a large retirement income.