We, and loads of others, have written about the importance of understanding safe or sustainable withdrawal rates when saving for retirement. How much will I be able to take out of my savings each year and not end up eating cat food should I be lucky enough to live to 80? Assumptions about this are key to the retirement calculators you find online, for example. The most commonly cited rule of thumb is 4%.
But what if we’ve all been worrying about the entirely wrong thing?
What if what we really should be focused on is saving and investing consistently?
That’s the thesis of a recent paper by (January 2011) Professor Wade Pfau of the National Graduate Institute for Policy Studies in Tokyo, Japan.
Pfau’s research lead him to the following “aha”: if you retire at the end of a long bull market, say, you may enjoy a low withdrawal rate because your savings is so high. But if that bull market is over, you won’t be able to expect much more growth as you move into retirement. On the flip side, if you’re retiring after a terrible bear market, for example, you may be withdrawing a larger percentage in year one and two, but your money stands more chance of continuing to grow in the future, ultimately bringing that percentage down.
Here’s how Pfau explains it on his blog:
Unlike the 4 percent rule, there is not a universal “safe savings rate,” but guidelines can be created. …What is clear is that starting to save early and consistently for retirement at a reasonable savings rate will provide the best chance to meet retirement expenditure goals. You don’t have to worry so much about actual wealth accumulation and actual withdrawal rates, as they vary so much over time anyway. But the savings plan should be adhered to regardless of whether it seems one is accumulating either more or less wealth than is needed based on traditional criteria.
Pfau notes that the focus on withdrawal rates may have lured some of us into not saving enough. “Recent Americans may have not saved enough or retired early because an outstanding market performance may have brought them to their traditional wealth accumulation goals earlier than expected. At the same time, someone saving during a bear market who is nowhere near reaching a traditional wealth accumulation goal may have given up saving or needlessly delayed their retirement, when it is precisely such individuals who could have enjoyed higher withdrawal rates.”
In his writeup of the study on Reuters, Felix Salmon describes Pfau’s basic calculation for what we might have to save:
Pfau makes a very basic calculation that for someone on a constant real wage, saving for 30 years and then living for another 30 years on 50% of their final salary, saving about 16% of your salary each year into a portfolio of 60% stocks and 40% bonds will put you into safe territory.
Of course, real wages aren’t constant over time, and all the other figures are highly variable too. But the bigger message certainly resonates with me: spend less effort on trying to boost your annual returns, when you have very little reason to believe in your alpha-generation abilities, and spend more effort on maximizing your savings every year.
Investing can be exciting, especially when it’s done wrong. You follow the markets rising and falling, you obsess about your retirement-fund balance, you rotate out of this and into that, you read books and magazines and blogs to try to learn more about what to do. You might even, in a moment of weakness, find yourself watching CNBC. Budgeting, by contrast, is like going on a diet: it’s a drag, and it’s hard to get any pleasure or excitement out of it. But the latter is much more likely to get you well-set in retirement than the former.
16% sounds steep, but somewhat possible. Of course, we don’t save anything like that right now — in 2009 the average American put just 10.1% of their paycheck into pension and retirement.
Correction: Professor Pfau’s was incorrectly identified as a professor at Princeton University in the original post. That is where he earned his PhD. He is a tenured Associate Professor at the National Graduate Institute for Policy Studies in Tokyo, Japan.