I think that the American public has largely tuned out the myriad studies showing that most households are woefully under-saving for retirement. Even if we’d prefer not to think about this issue, however, it is crucial to regularly check on how we are doing. There are two major questions. First, during your working years, are you saving enough? Second, during retirement, how much income can you sustainably plan to draw from your savings each year? The good news is that there are some simple tools that you can use to do a fast estimate of how you are doing, how much you need to save to stay on track, or how to get on track.
The determination of how much we need to save and how much income our savings can provide in long-term retirement income has been thoroughly studied. Across a range of assumptions about how we save and how we plan to ‘draw down’ our assets in retirement, the numbers ultimately converge to some pretty consistent results. There are a number of ways that the basic results can be made more sophisticated, but simple estimates get you most of the way to the standard financial planning answers.
Two Simple-But-Powerful Estimates
I have found two very useful tools that can help you quickly estimate how you are doing, one for your working years and one in retirement
The first of these provides estimates of how much you need to save each year, given your age, income, and current retirement savings. The Ibbotson tool (which is implemented in a very simple calculator on Morningstar’s Personal Finance page):
You simply enter your age, your current retirement savings, and your income, and the tool calculates your target savings rate. The more you have already saved, the lower your savings rate. This tool assumes that you need 80% of your pre-retirement income in retirement and also includes estimates of Social Security income and assumes retirement at age 65. While this tool is simple to use, the analysis behind it is quite sophisticated.
Let’s say that you are 50 years old and you have saved up a total balance in your retirement account of $300,000. The Ibbotson tool estimates that you need to save 20.5% of your income each year towards retirement, from this point onwards (see example below). The calculations assume that your income will increase by 2.5% per year and that your cost-of-living in retirement will also increase by 2.5% per year. So, this year you will need to save $20,500 (20.5%x$100,000), next year you will need to save $21,012.50 (1.025x20.5%x100000), etc.
If, on the other hand, you have saved $500,000, your required savings rate is 12.7% of the assumed $100,000 of annual income, and this savings amount will increase at 2.5% per year. The calculator includes the fact that, as your income grows, Social Security will comprise a smaller fraction of your total income in retirement. The calculations assume that you invest your money into an asset allocation consistent with ‘target date’ funds, which reduce your exposure to stocks and other risky assets as you age. In addition, the calculations assume that you will purchase an annuity at retirement with the full amount of your retirement savings. While there are many other ways to save for retirement and to plan to spend down your assets in retirement, this calculator provides a good quick way to see how you are doing. If the estimated required savings rate is above what you are currently saving, this is a warning sign. If, on the other hand, the estimated required savings rate is lower than your current savings rate, you may be able to plan to retire earlier or to plan for a higher income in retirement.
If you plan to use your accumulated savings to purchase an annuity when you retire, you can quickly and easily see how much lifetime income your savings will provide by calling insurance brokers or consulting an internet listing (www.immediateannuities.com, for example). For those people who either choose not to annuitize or who annuitize only a part of their portfolios, the crucial issue in retirement is how much you can realistically take in income without risking running out of assets in your later years. The second tool, developed and tested in a just-published article by David Blanchett (the head of retirement research at Morningstar) addresses this question and is available from Blanchett’s website as an EXCEL spreadsheet. This spreadsheet calculation uses formulas fitted to simulation model results. I am very familiar with this type of analysis and the results look reasonable. Blanchett’s tool comes up with the amount of income that you can realistically plan to draw from your savings each year, as a function of your stock/bond mix, your age, and how confident you want to be that you don’t run out of money. A fairly standard assumption is that you want a 90% confidence in being able to fund a 30-year retirement if you retire at age 65. For a 65-year old, with a 50% allocation to stocks and a 50% allocation to bonds, and a total portfolio expense ratio (fund expenses plus any fees to a personal advisor), the safe withdrawal rate is 3.5% per year. This means that he or she can plan to draw $35,000 from a $1,000,000 portfolio and adjust that amount upwards with inflation each year.
The old rule of thumb was that you could plan on a 4% withdrawal rate, but a range of recent analysis suggests that this is probably too high today. The original ‘4% rule’ also assumed that you determine how much income you will draw and increase this amount by 2.5% per year to keep up with inflation. Blanchett’s tool has the added benefit of allowing you to potentially adjust your income draw as you age. You might start out with $35,000 in 2013 dollars from a $1,000,000 portfolio and then find at age 70 that you can increase your income because you are five years into retirement and your portfolio has performed well. This is a benefit because a number of studies have shown than continually adjusting your retirement income to reflect your current age and wealth tends to reduce the probability of running out of money and thereby maximizing the amount of income you can safely draw
Another useful feature of Blanchett’s tool is that you can look at the income impact of retiring earlier or later than age 65.
Just Sixty Seconds
If you are in your working years, you can get away with just looking at the Ibbotson tool and you should be able to go through it in about a minute. If you are approaching or in retirement, you can just look at the Blanchett tool. I have worked on these types of calculations for a number of years and I believe that these two tools can provide a fast but reasonable estimate of your long-term financial outlook.
A recent study finds that two thirds of American households comprised of one or more working people between the ages of 55 and 64 have retirement savings less than one times their annual income. There are important questions and limitations with regard to these estimates, however. The Ibbotson study, and others like it, assumes that people will need around 80% of their pre-retirement income to support them in retirement. The reasonableness of this type of target income replacement rate is not obvious. If these numbers are even close to reality, though, a run through Ibbotson’s calculator will be scary. For a 55-year-old making $100,000 per year who has $100,000 in saving, the required annual savings rate until retirement is 36%.
Similarly, a 65-year-old who retires with $500,000 saved in a portfolio that is 50% allocated to stocks and 50% allocated to bonds would expect to be able to draw $17,500 in annual income to supplement Social Security (following the example from Blanchett’s tool, above).
For many people, the numbers coming out of these calculators will be a shock. It is far better, however, to have the chance to change your lifestyle today than to reach old age and suddenly find yourself facing a lifestyle far below that which you enjoyed during your working years.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.