I read an article entitled, “Are You Saving Too Much for Retirement?”
I think it is a good article to discuss. No, the article itself is not good. Far from it. Rather this type of article is good to discuss. A big difference.
First, let me say that I do not like to criticize other writers. Everyone has their own perspective and that is fine with me.
But too often I come across information that is just plain bad. And if read by someone with limited investment knowledge, can lead to potentially terrible results.
Today is one of those days.
It turned into a long post, sorry. But it drives me crazy seeing terrible financial advice out there.
Let us go through some key points from the article.
One Size Fits All
Retirement planning almost always starts with one number: A guesstimate of the percentage of pre-retirement income you’re expected to need after you retire. That’s called the “replacement rate” and is often pegged by industry experts at around 80 percent of a household’s earnings.
Perhaps I am not an “industry expert” (although my professional designations and experience would say I am) but good advisors would not arbitrarily assume an 80% figure.
If they did, that indicates that a household earning $2 million per year requires $1.6 million in retirement. And a household earning $40,000 requires only $32,000 annually in retirement.
Should you live in retirement as your earned in your work life? Maybe.
I would say maybe not. Your retirement income should be a function of your lifetime savings, not a guesstimate based on pre-retirement earnings.
You Need Solutions That Fit You
Competent advisors conduct a needs test to help determine your potential requirements. It incorporates a variety of factors and should be based on your unique circumstances.
One one side you have existing costs. At retirement, you likely will no longer have a home mortgage, car loan, education costs for your children, etc. You will not have employment related costs, such as transportation each day, dry cleaning, tools, eating out, etc. In many areas your costs will sharply fall.
What percentage depends on your personal circumstances. The choices you made in life. And what you chose will likely be different from your neighbour.
Countering this are the potential new costs in retirement. If your family history is of long life, you may want to plan for a longer retirement period than the average person. Or if you have been diagnosed with a medical condition, you may need additional funds to deal with it. If you want to travel the world or live in a tropical paradise, that needs to be considered. If you want to engage in philanthropic activities, that needs to be calculated.
The list of retirement needs and desires is endless. And in a package they are unique for each individual.
One size does not fit all. It is a mistake to think so.
It is even a bigger mistake to rely on an advisor that uses this system to plan.
We May Be Saving Too Much
In the article, Ms. Bonnie-Jeanne MacDonald thinks people may be saving too much and that they do not need to make that level of sacrifice for a comfortable retirement.
That has big implications for workers who are now exhorted on a daily basis to save more and more, ‘lest they run out of money in retirement. If you really don’t need 70 percent or 80 percent of your last paycheck for the rest of your life, you don’t have to save enough to produce that figure. And saving too much has its consequences, says MacDonald.
“It’s not coming from nowhere; it means you’re making big reductions in your standard of living before retirement to make your standard of living higher after retirement,” she explains.
A fair bit of nonsense.
First is the assumption that one does not necessarily need 70-80% of one’s last paycheck to have a pleasant retirement. This may be true or not. As we saw above, it depends entirely on the individual in question.
Second is that saving more will result in significant reductions in one’s current standard of living. How does she know? Accumulated wealth is a function of multiple variables. How you use them dictates the level of sacrifice.
Third is that saving more will result in a higher standard of living in retirement. Maybe, but maybe not as we shall see below.
We will look at the second and third points below.
Saving Money Requires Significant Sacrifice
Wealth accumulation is based on many factors.
Some factors may cause saving to involve significant sacrifice. But proper planning can make the process manageable. Also, I would rather sacrifice a little during my earning years than to reach 65, with no employment and not enough enough wealth to live above the poverty line.
But perhaps that is just me.
We covered a lot of wealth accumulation factors in our review of compound returns.
Time is a huge component of accumulating wealth. If you start at age 25, you can contribute much less, both periodically and cumulatively, than if you wait until 35 or 40 to start saving.
Perhaps I want to save $1 million at age 65. I am starting with zero saved and have annual after-tax income of $50,000. Further, I am guaranteed a return of 6% per annum. If I wait until I am 45 to begin saving, sure it will be painful. I will need to save about $2200 per month and contribute $528,000 over the 20 year period.
But if I start saving a little younger, the pain eases. Starting at 35, I only need to save about $1000 per month and contribute $380,000 in total over 30 years. And if I begin at 25, my monthly contribution falls to $500 and my total drops to $240,000.
Maybe I have to budget a little better when young, but $500 per month is preferable to $2200. Not to mention that as I age, I will have more disposable income that I can allot on top of my monthly requirement. This will grow my nest egg even more.
Start investing as soon as you can. Even if it is a limited amount, it will grow nicely over the long run.
Rate of Return
Rate of return is also key to wealth accumulation.
Many planners use historic rates of return to extrapolate future returns. For U.S. large cap stocks, that equates to 7.4% net of inflation return. For bonds, 2.4%. For Treasury-bills, 0.7%.
Smart advisors often incorporate a bit of conservatism in their calculations for safety.
For example, T. Rowe Price currently uses the following assumptions in their expected rate of return calculations “all presented in excess of inflation: for stocks, 4.90%, for bonds, 2.23% and for short-term bonds, 1.38%.”
I might be a little more cautious than T. Rowe Price. I would rather err on the low side and end up with excess wealth than to be too optimistic and have to live on Kraft dinner and popcorn.
In our example above, I used a 6% rate of return. At 25, I need to contribute $500 monthly to reach $1 million by age 65. If I only achieve 5% annually, my end wealth would only reach $763,000 at age 65. At that return I need to increase my monthly contributions to $660 to reach $1 million.
On the plus side though, if I can eke out an extra percent to 7% annually, my $500 per month will grow to $1.3 million by age 65. Not a bad incremental return just by earning an additional 1% return.
As an aside, this shows the importance of prudently taking on additional risk (with higher expected returns) if you are a younger investor.
Saving Now Will Result in a Higher Standard of Living Later
And this is a bad thing? It seems so according to Ms. MacDonald.
I would not mind living a better life than I do now. I think many people share my opinion.
But will saving now necessarily lead to a higher standard of living in retirement than we enjoy now?
Possibly not. Why?
Prices Never Stay the Same
You spend $10,000 on a vacation today. If inflation is 3% (the U.S. historic average) over the next year, that same trip will cost $10,300. Okay, maybe not that bad.
But how about if you are 40 and want to take that dream vacation at age 65. Inflation of 3% over 25 years will make that same vacation cost around $21,000. Or if you are only 25, that vacation will balloon from $10,000 today to $32,600 in 40 years.
A bit of difference in your planning requirements.
And who is to say that inflation will maintain its historic average of 3%. Globally, governments are running substantial deficits leading to historically high debt levels. Money is being printed to help deal with economic crises. All these can create higher inflation.
And what if you are low on your inflation estimates? Say you factor 3% when it turns out to be 5% on average. That $10,000 vacation now becomes $34,000 in 25 years and $70,000 in 40 years.
Think that 5% is not possible? Talk to someone who experienced the late 1970s or early 1980s. In 1980, the U.S. inflation rate reached 13.6%.
And for those that believe inflation will also be reflected in higher salaries and investment returns, not correct.
For wage earners who have Cost of Living Allowance (COLA) clauses that provide annual wage increases to account for inflation, there are difficulties. Namely in that often the official inflation figures omit key items that impact consumers.
For investors of fixed income assets, only those on the extremely short end can somewhat keep pace with inflation. But if you buy a 10 or 30 year bond that yields 5% and inflation increases to 6% during that period you will have negative real returns.
Again, err on the conservative side when factoring inflation into your retirement needs analysis.
Taxes Will Rise
What you pay today in taxes will not be the same as when you retire (assuming more than 5 years out).
National, regional, and local taxes will rise. Both direct and indirect (e.g. taxes on gasoline). They have to in order to finance the huge government debt loads, social welfare services, and pensions for government employees.
User fees will also rise and new fees will be introduced. I call these taxes, but government calls them fees, so I will play the game. These fees will be imposed in areas where they will raise revenue. As an increasing number of people are retiring, look for new and/or higher fees in respect of leisure activities.
When calculating your net retirement income, factor in higher tax rates than are experienced today.
Pensions Will Fall
Many people expect government pensions to offset their other retirement income.
This is a mistake.
Over time, governments will cut back on social welfare pensions simply because they cannot afford them. This may be in the form of clawbacks (i.e. means testing), higher age requirements, reduced payouts, etc.
As well, there is the potential for individuals who are entitled to defined benefit pensions to suffer from reduced payouts. Many corporations and governments are significantly underfunded in financing employee pension schemes. If you are in such a situation, there is a possibility that you will not receive what you are owed.
When calculating retirement needs, do not blindly include government old age pensions. And have a little skepticism if you are a member of an underfunded defined benefit pension plan. If you count on these income streams to finance your retirement fund shortfall, you might be in trouble.
Despite your savings pattern, there are no guarantees that you will enjoy a better lifestyle in retirement than you do pre-retirement.
A Lot of Doom and Gloom
Okay, that was a lot of doom and gloom.
But it is important to always take a conservative approach when planning for retirement. This notion that we are saving too much and need not sacrifice anything for retirement is insane. Possibly economically suicidal.
With luck, we will see the return of strong bull markets with little inflation. These will lead to higher personal and corporate incomes that will pay down government debt and allow for lower tax rates and continued social welfare payouts.
I have my doubts, but let us say it we do get lucky. What is the worst for you? You scrimped a little during your work years and ended up with a pile of excess retirement capital. Not bad.
We can take all our extra wealth and build a monument to Ms. MacDonald in tribute to her vastly superior intellect.
But if we do not get lucky, where are you? If you follow the wisdom of Ms. MacDonald, you are in big trouble. May I suggest at that point you give Ms. MacDonald a call for financial assistance. I am certain she will give you a hand. Or not.
However, if you do save as much as is possible under a proper investment plan, you may still be okay. At least better off than many of your peers who did not properly plan.
Hope for the best, but plan for the worst.
If you do, you will be miles ahead of most people.