Retirement is just a function of three primary factors: savings, spending, and rate of return.
Control the things that are most controllable, namely the savings and spending.
Retirement planning today can contain a lot of different tools that we think are needed to avoid sequence of returns risk.
There are essentially three primary variables that factor into the success rate of retirement- as measured by the total accumulated at retirement and how much is left as inheritance:
- How much you save before retirement?
- How much you spend during retirement?
- The rate of return on your assets
The first two are the one's that the investor has complete control over. They can decide to save more or decide to spend more- to the benefit of or at the expense of their future account balances. They can also decide just how much they will spend during retirement.
So many investors focus squarely on the third bullet point, achieving the best rate of return. It's almost like a "free lunch," as if generating an extra 100 bps per annum means they can buy the BMW now instead of the Ford. But there's simply no way to know that you can maintain the outperformance over several decades. If you do, you would be up in the realm with legendary investors like Warren Buffett, Carl Icahn, and Benjamin Graham.
In other words, do not count on your ability to earn a higher rate of return in order to cover your behind for not saving enough.
Let's walk through the first two primary variables in more detail.
Saving for Retirement
How much should you save? The old adage of save early, safe often rings true and is the most sage advice out there. How much you save is a function of your age and your aspirations for retirement (how much you want and how early you want to stop working). Experts typically put out the 15% of gross income number as a savings target.
A study by the International Longevity Centre found that the "average" American needs to save somewhere between 11% and 18% of their income in order to produce a "comfortable retirement." That number may be too low if you do not start saving until you're in your thirties. The main issue is that only one in ten Americans are actually saving that amount.
The most typical vehicle to save for retirement is the 401(k) plan. Individuals today can park away as much as $18,500 per year plus the company match. If you cannot defer that much, at least put in enough to take advantage of the entire employer match. The "all sources" contribution limit is $55,000. When you are in your twenties and even part of your thirties, the amount you contribute to the plan is typically significantly above the returns of the account. However, at one point you hit a crossover point where the account becomes large enough that smaller percentage moves are much larger than the contributions being made regularly.
One of the most powerful tools that we are often discussing is the Roth IRA. This is a rare bucket that most investors seem to lack. The income limit and the lack of knowledge by investors means that this account type is often left behind and ignored.
The income limit on the Roth IRA is $188,000 of modified adjusted gross income (MAGI) but starts to phase out as early as $118,000. So the tool is often out of reach for many people when they finally have the money to sock away.
The power of compounded interest has been called the eighth wonder of the world. Starting to save early is imperative, even if it is just $100 per month, less than the cost of a cup of coffee per day.
Spending During Retirement
The amount that a retiree can spend once they stop working can be highly variable. So many people focus on the rate of return, as we noted, and the amount they save, but little attention is placed on how much they can or should spend. For an effective retirement plan, you need to have an accurate idea of what the annual spending is going to be. In many cases, this can be the hardest question a financial advisor asks a client. Most of the time the answer is just a blank stare back.
A great rule of thumb to estimate the amount likely to be spent is to look at your gross income and then:
- Subtract out taxes paid
- Subtract out savings for retirement
- Subtract out health insurance expenses if at age 65
- Subtract out job-related expenses (work clothes, commuting expenses, etc.)
What is left, if it isn't saved for retirement or part of your taxes payable has, by definition, been spent. Let's run through an example:
Mary and Joe have adjusted gross income of $150,000 per year combined. They paid $20,000 in taxes last year and both maxed out their 401(k)s for a total of $37,000 (leave out the match). The remainder is $93,000 which is what they spent throughout the year on "stuff"- what it took to maintain their lifestyle including mortgages, health insurance, car payments, food, etc.
Many advisors use a replacement ratio to forecast a level of spending during retirement. This is the income you made in the last three years before you retired and figure out the amount of income needed to maintain your lifestyle during retirement. Most people end up spending less during retirement than they did during their working years. Replacement ratios for people who had household income in excess of $100,000 are around 50%-65%.
Some people spend more in retirement as they have more time to travel, shop, play golf, and enjoy life. But this is typically a temporary stage. We often see three phases over the course of retirement:
- Early Retirement (Age 60-75): highly active, travel, highest spending levels
- Mid-Retirement (age 75-85): Less active, lowest spending levels
- Late-Retirement (age 85 and up): Highly inactive, can be highest spending based on health care expenses, long-term care, etc.
The late stage can be extremely burdensome in terms of cost if the individual has to be placed in a memory care or assisted living facility and no long-term care insurance was purchased. Health-related expenses are typically one of the reasons the late stage can be one of the most expensive.
The Rate of Return on Assets
This is the factor that is more or less out of the investor's control. While prudent portfolio management can produce better returns than not, the market and interest rates will do what they are going to do. Actively managing the portfolio - unless you are one of the legendary investors named above - is likely to result in very little additional benefit during the working years.
For those that are young, we would recommend having a significant overweight to stocks. Over the long run (10+ years), stocks will outperform bonds. For risk averse investors, having some allocation to bonds to reduce volatility can be warranted but just know that will likely reduce the account balance down the road.
There are dozens of free retirement calculators where you can put in a current salary and a savings rate and it will spurt out what your account balance will be at retirement. Many of them will let you adjust the return assumption. We like using a reduced figure of 5.5% or 6% (depending on age) to factor in likely lower long-term returns.
While many financial advisors simply assume a flat (level) rate of return, actual returns are far from it. The standard deviation of equity returns as measured by the S&P 500 benchmark is just under 16% (68% of returns are between -8% and +24%) over the last 40 years. For small cap, real estate, and international benchmarks the number is much higher.
And as we've discussed many times, almost ad nauseum, returns achieved on your portfolio between age 55 and 70 are by far and away the most important of your life. This is the sequence of returns risk, which we detailed previously, that can permanently impair your retirement. Most financial advisors are simply ignoring this but during the withdrawal period (when you start taking distributions from your portfolio) down years can have a massively damaging effect on the longevity of the portfolio.
The Bottom Line
Retirement can be a scary process as you have to plan many decades before in order to create a large enough nest egg. Most people either start saving too late or not enough for it to last. Unfortunately, we think there will be a retirement crisis within the next 10 to 15 years as a market decline will be coupled with low retirement capital.
We've discussed the three primary variables that influence how much capital you have and how long it will last during retirement. Two of those variables are within their investors' purview. Taking advantage of that control is imperative.
The third factor, how much those assets return over time, can be highly variable during any given time frame but over long periods, will likely average close to or slightly below historical averages. But the most important time period for investors are those that are in the "red zone," with an age between 55 and 70 years of age.
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