How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

It is worth stopping and thinking about the implications of these results.  While there are quite a few uncertainties, the result of analyses like Pfau’s are that a retiree with a $1 Million portfolio should plan to draw only $30,000-$40,000 in income this year.  Recent data shows that the average 401(k) account balance is $165,000 for workers aged 55 and above.  It is also worth noting that only 81% of households with a head of household between 55 and 64 have any retirement plan assets at all, including traditional pensions, IRAs, and 401(k)’s.  The remaining 19% will be relying on Social Security for retirement income, the equity they have in their homes or other unidentified assets.  Using the estimates discussed above, someone retiring at age 65 should plan to draw only $3,000 in income per year for each $100,000 invested.

Clearly, this is a big issue for everyone who will be relying on their own savings to fund their retirement.  There are some inescapable conclusions from looking at the current levels of account balances in 401(k) plans and calculations such as Pfau’s.  First and foremost, many people need to save considerably more than they have.  This will, of course, be impossible for some people.  For others who could scale back on discretionary spending in order to save more, saving should be a high priority unless they are already a really good saver or expect to inherit a considerable sum.

As a baseline way to estimate how your savings plan is working, start with Morningstar’s Retirement Savings Calculator, based on this excellent research paper.  Note, however, that this calculator uses long-term historical rates of return for stocks and bonds, rather than estimates based on current bond yields and P/E ratios, so the estimated necessary savings rates will need to be higher than the number reported by the calculator if you accept Pfau’s very sensible premise that current valuation levels matter.



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