Saving and Investing for Retirement: Part Two

Figuring Out Whether You Are On Track: Part Two of Our Special Five Part Series

Fidelity just came out with a study that estimates that people will need about eight times their final salary level, assuming they work until age sixty seven, to be able to retire and subsequently to have 85% of their pre-retirement income provided from retirement savings plus social security.  Fidelity also helpfully provides estimates of what they believe people need to have acquired at different ages.

Age In
Savings Target
0.5 times current salary

Source: Fidelity

According to Fidelity, you need to have saved up an amount equal to your annual salary at age 35 and twice your annual salary at age 40.  If you are making $50,000 in salary at age 35, you need to have $50,000 in your 401(k) plan in order to be on track.  As with any study of this kind, there are many simplifications and assumptions.  The analysis assumes that investors will make a risk-free 5.5% return on their investments and that salaries will increase each year by 1.5% beyond inflation.  There is, of course, no way to get a risk-free 5.5% return.  The 5.5% may be a reasonable estimate of what a portfolio of stocks and bonds can be expected to provide in the future, but by ignoring the impacts of market risk you end up with a very optimistic outlook.  The idea that salary growth will exceed inflation by 1.5% is also problematic.  After you correct for inflation, household income has dropped in the U.S. over the last decade.  In fact, median inflation-adjusted household income is barely above where it was in the early 1970s.  My goal here is not to criticize Fidelity for its study but rather to note that their estimates are probably on the low end of what is needed.

One of the things that I like about Fidelity’s guidelines is that they focus on a simple and easily calculated measure of retirement preparedness: the ratio of wealth to income.  This measure is easy to calculate and track.  This ratio can be used to further delve into the relative contribution to income that might be provided by assets aside from retirement accounts.  The Center for Retirement Research (CRR) at Boston College has published national average wealth-to-income ratios using survey data from Federal Reserve Board’s influential Survey of Consumer Finances (SCF).  Wealth, as measured by the SCF, is the value of all assets including home equity, retirement accounts, other investments and privately-held businesses.  For people between ages 62 and 64, the national average for total wealth is slightly below four times income.  The CRR analysis shows that, in 2010, the average Wealth-to-Income ratio for people between 44 and 46 years of age was 1.6.  Fidelity projects that 45-year-olds need to have retirement savings of 3 times income.  In other words, even if we include home equity and other assets, mid-career household wealth is about half of what Fidelity projects is needed in retirement accounts alone.

Another study and guidelines that I find useful was created by Ibbotson Associates and there is a quick calculator at that applies their research findings.  The tool is available on Morningstar’s Real Life Finance page:

Rather than expressing the results in terms of savings as a multiple of income, this calculator has you enter your age, your income, and your current savings amount.  The tool then estimates how much you should be savings going forward.  If your current savings rate is as high as the target savings rate that the calculator produces, you are on track.  If your current savings rate is below what the calculator tells you that you need, you need to save more.  You might also find that your current savings rate is too high and that you can afford to save less.

The Ibbotson calculator is based on a study that includes the effects of market risk and assumes that investors put their money into asset allocations that are typical of target date funds, with exposure to stocks and other risky asset classes declining through time.  In other words, unlike the Fidelity study, the Ibbotson research includes the effects of risk.  One output from this study is a table that is similar to the one from Fidelity that allows you to estimate whether you have accumulated an appropriate amount at each stage in your life.  This table, reproduced below, differs from Fidelity’s in that it breaks out savings levels by income.

Income $20,000
Income $40,000
Income $60,000
Income $80,000
Income $100,000
Income $120,000
35 $0 $0 $0 $0 $0 $0
40 $7,692 $21,824 $39,176 $58,674 $78,710 $103,038
45 $16,005 $45,408 $81,512 $122,082 $163,768 $214,387
50 $26,023 $73,831 $132,533 $198,497 $266,277 $348,581
55 $37,434 $106,207 $190,650 $285,540 $383,042 $501,436
60 $51,562 $146,292 $262,607 $393,310 $527,612 $690,691
65 $68,650 $194,775 $349,637 $523,658 $702,467 $919,594
Income is gross income. Savings start at age 35.

Source: Ibbotson et al, 2007.

The table above, from the original article, assumes that people start saving for retirement at age 35, so the projected necessary savings does not match up with the Fidelity guidelines when investors are younger.  For a person making $100,000 per year, the projected necessary accumulation is $702,467 at age 65, very close to Fidelity’s estimated 7X salary.  For people making substantially less income, the necessary wealth accumulation is lower because Social Security is likely to make up a larger portion of their income needs.

The Ibbotson results, published in the Journal of Financial Planning in 2007, are based on very different assumptions than those used by Fidelity but yield similar results for the projected wealth needed to fund retirement.  Ibbotson assumes, for example, that the S&P 500 will generate an average annualized return of 10.96% (see Table 5 in the article).  This is a very high level of expected return for the S&P 500.  The Ibbotson results account for risk (using annualized volatility of 20.2% for the S&P 500), which is why the projected savings targets are not considerably lower as a result of the higher expected portfolio returns.  At retirement, the Ibbotson results assume that investors hold a portfolio with 46% stocks and 54% bonds, which corresponds to an expected average annual return of 7.51% in their analysis.

These types of studies provide guidelines for how much people need to accumulate in order to fund their future retirements.  In practice, of course, a lot more information is required in order for a family to determine that they are on track to providing for long-term income needs after retirement.  Despite the idealizations in this type of analysis, the overall conclusions are quite reasonable.  Investors who have considerably less in assets than the goals established by these two studies need to ramp up their savings rates or plan on working later in life than age 67.  It is important to realize, however, that working longer may not be an option due to either the job market or due to more prevalent health issues as we get older.

The real world of investing also consists of expenses, as well as the consequences of bad decisions made by individuals.  People often panic and jump out of the market during downturns or get overly bullish and take on too much risk during rallies.  In the next part of this article, I discuss factors that have historically been major hurdles to successful retirement investing and why well-designed Target Date strategies are a good solution for many people.

Related Links:

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5 thoughts on “Saving and Investing for Retirement: Part Two

  1. dan knight

    seems to imply balances that are too low with current sustainable withdraw rate research. Example – assume $100k income, 80% replacement, 30 year retirement, SS provides $25k, thus need $55k from the portfolio, the above shows a balance of $700k at 65. $55k/$700k = 7.8% initial withdrawal rate, much too high for sustainability.

  2. Geoff Considine Post author


    I agree–the withdrawal rates look high to me. I tend to be more on the AON side of the argument with more like 11X income at retirement.

  3. Pingback: Saving and Investing for Retirement: Part Three « Portfolio Investing Blog: Portfolioist

  4. Pingback: Saving and Investing for Retirement: Part Four « Portfolio Investing Blog: Portfolioist

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