Oxstones Investment Club™From www.millersmoney.com, By Dennis Miller
Human beings are, by nature, heuristic. Although we are immensely intelligent, our brains are not attuned to mathematical precision. Instead, we are wired to make quick decisions based on limited information gathered from experience.
This quality was helpful for avoiding saber-tooth tigers on the savannah, as it allowed us to make split-second decisions when we heard a rustle in the grass. Had we evolved to stop and calculate the exact odds that the noise was, in fact, a predator and not just a stray gust of wind, we might have been wiped out long ago. Our evolutionary tendencies are obviously advantageous when it comes to not being eaten, but they can hinder us in modern life.
There are times when we must put aside our heuristic selves and actually crunch the numbers. Saving and planning for retirement is one of those times. You can’t simply put the problem off and assume it will work itself out. It won’t.
This is Alex Daley, filling in for Dennis this week while he enjoys the Arizona sunshine (which sounds quite nice to this guy, as we enter the fifth month of Vermont frost).
Unlike Dennis, I won’t retire for several decades. At my age, I think more about whether to spring for those new quartz countertops and send the kids to private school than how my life will look a few decades from now and what I need to do to get there.
Nevertheless, when I sit down to do my taxes each year, I also take stock of my full financial picture. How did I do for the year? What do I need to do differently? And so forth. It is the one time every year when I look closely at the numbers and objectively assess my performance.
It’s like an annual performance review for my second job. And, like the reviews at my corporate jobs of the past, it isn’t always fun. There are many awkward moments as I step back and analyze a year’s worth of quickly made decisions. But it is necessary, as it forces me to confront my faults and make improvements. Without that, we are doomed to repeat our mistakes indefinitely, and the problems they cause compound ad infinitum.
I encourage everyone I know to take a day, dig out the yellow pad and calculator (or the iPad), and start adding up the score. Whether you’re on your first lap or your hundredth, you have to know where you are before you can decide what to do next. And that begins with knowing what your long-term goal is.
In other words, how much money do you need to retire? Once you know that, you can fairly judge whether you’re making sufficient progress.
But what exactly is that number? How much do you need to save? The answer depends on how you want to live in retirement and the way you want to retire – meaning how much security you need to enjoy the time you’ve earned.
There are basically three ways to retire:
- Off the interest;
- Off the principal; or
- On the dole.
Or, of course, some combination of the three.
Living Off the Interest
Living off the interest of your savings is, of course, ideal. That’s because it eliminates the single biggest fear retirees have: “Will I outlive my money?” If your savings is significant and invested well enough to pay for your current needs and keep up with constantly rising prices, you can rest assured that whether you live to 76 or 106, you can continue to live comfortably.
It is the ideal situation, but it is obviously the hardest to achieve. Short of winning the lottery or inheriting a family fortune, we must save diligently to get there. How much exactly?
To find that number, you must decide how you want to live during retirement relative to how you live today. If you live in a trailer park in the Mississippi delta and you want to retire to a palatial mansion in Palm Springs, you’ll have different goals than if you were content to stay put, living the same lifestyle you currently live. In reality, most of us probably want to live about as comfortably as we do today, give or take a few meals out.
So, let’s imagine that you’re part of a married couple with a healthy family income of about $85,000 per year, and your goal is to maintain your current lifestyle throughout retirement. If you can pay off your mortgage and keep your housing expenses down during retirement, and benefit from some of the lower income tax rates on investments, then maybe you could get away with living on about 75% of your previous gross income.
That means your investments would need to earn about $63,750 in income annually. If you want your retirement income to be stable, you’re going to have a pretty conservative portfolio, filled with things like bonds and CDs. Today, if you can squeeze 5% out of those kinds of investments, you are doing quite well. With that kind of return, you’d need at least $1.275 million saved to meet your goal.
That, however, is as the accountants say, “in today’s dollars.” That figure will actually have to be much higher to make up for inflation’s detrimental effects. If you’re 30 years old today, plan to retire at 65, and inflation runs at about 3% annually (according to the government’s statistics), then you’ll need to bring in $180,000 per year to live the same lifestyle in the future. And that 3% estimate may be an undershot. We know how the government likes to artificially suppress that figure to avoid paying out more in benefits; its average inflation rate has been 2.4% for the last decade – vastly different from the Money Forever Reader Poll Inflation Rate of 8%.
Nevertheless, assuming that inflation runs at 3% a year, you’ll need at least $3.6 million in savings to live solely off of interest income starting in the year you retire.
If that number isn’t daunting enough for a couple earning $85,000 per year, think about the effects of inflation after you retire. If you only had $3.6 million, you’d need all of your return to live on; meanwhile, you’d be losing money to inflation. Essentially, you’d get a 3% pay cut during each year of retirement.
If you lived to the ripe old age of 90, your retirement income would have fallen to the equivalent of under $30,000 per year – in today’s pre-tax dollars – by the end of your life. If you want to keep your income at the equivalent of $63,750 (75% of today’s salary), you need to earn an additional 3% in return every year, or save an additional $5.4 million.
In other words, if you’re 30 years old today, to live indefinitely like an $85,000-per-year couple, you’ll need to save just shy of $9 million to retire at age 65. That’s a laudable goal, but virtually unattainable without very aggressive investing and quite a bit of good luck.
You can make a sizable dent in those numbers by using tax-advantaged savings accounts, like a Roth IRA. But in reality, even with aggressive savings, good investing, and smart tax management, most mere mortals never reach that goal. Instead, most will have to draw down their savings in addition to living on interest.
The Reality of Principal Draw Down
When you cannot rely on interest alone, you have to dip into your savings. And since the bank is unlikely to let you draw your account down below zero, as morbid as it might seem, you have to plan for how long it (and you) will last. That’s one heck of a gamble in an age of increasing life expectancies, but a necessary one for most.
If this is your plan, your retirement income will look something like this estimate from CalcXML.com:
That’s a scary cliff at the back end if you happen to hang around for a few extra years.
However, when you plan to draw on your savings, suddenly the amount you have to save drops dramatically. Instead of $9 million, you only need $3.4 million, assuming the same 5% post-retirement investment performance.
To many, that still feels like a lot more than they expect to see in their lifetimes. However, unlike the previous example, for a couple with the same $85,000 annual income, it is within the realm of attainable. So how much do you have to save to get there?
If you are starting from scratch at 30 years old, your investments are entirely outside of tax-advantaged accounts, and you assume a return equal to a decent overall stock market fund – i.e., about 5% in annual returns after fees – then you have to save 29.8% of your income, starting with about $23,339 this year.
Obviously, if you are going to fund your whole retirement on your own, you’ll need to earn much more than 5% on your investments. For instance, if you can get to 8% after fees – on the edge of possible with index funds, if you stash it all away in 401(k)s and other tax-deferred accounts – then you’d reduce that number to 16.8%.
That drops your yearly savings burden to $14,299 – just within the limits of the modern 401(k), and maybe possible for someone living on that $85,000 salary (assuming their kids get college scholarships and they resist buying that Mercedes).
Start when you are 25 instead, and you only have to save 12.6%.
So, with very aggressive savings, strong tax management, and returns on the edge of the US’s best decades, you might eke it out on your own. At least until age 90 when your accounts run dry, after which you’ll have to turn to relatives or the state for help.
The “Guaranteed” Safety Net
Maybe the idea of saving about $1,000 per month every month for 40 years without fail isn’t that daunting to you. But for most people, it’s just not possible. Instead, many of us (far too many, since Federal Reserve statistics say that more than 60% of citizens have next to nothing in the bank) have trusted our retirements in whole or in part to Social Security.
Assuming that the program is still in place when today’s young professionals head to retirement, its effect on what you have to save is dramatic. If Social Security benefits keep up with inflation, the savings burden for today’s 30-year-old who is just starting out could drop as low as 6.2%, or $5,350 this year, perfectly within reach for anyone with that income.
That is why so many people just write off their retirement savings to the government, or to defined-benefit pensions. It’s not uncommon for teachers, electricians, auto workers, boilermakers, and the like to rely on pensions for most or all of their retirement. If you are one of the lucky few who still enjoy a pension from a previous employer, count yourself among the nation’s wealthy. That $40,000 annual pension with healthcare coverage is literally worth millions of dollars to the average retiree. This is something Dennis has commented on before.
While many pensions are still secure today and Social Security continues to pay out, neither is guaranteed to last forever. In fact, both are showing rapid signs of deterioration.
Social Security, for instance, has been effectively reduced in recent years thanks to the gap between real inflation – the price of food, energy, and other necessities – and the government’s regularly manipulated and rejiggered Consumer Price Index (CPI), on which benefits are indexed. The end result is that the real value of Social Security benefits is reduced. And in the process, your savings burden increases to make up the gap.
If the government holds the CPI at 1.5% while the real inflation rate is 3%, our theoretical 30-year-old couple would have to save over $650,000 more to make up the difference. That would require saving another 3.8% of their current income, or $271 per month.
Moreover, this tampering benefits the government by reducing the cost of Social Security relative to wages, letting them spend more of the entitlement money on discretionary programs (i.e., buying votes). So the trend is unlikely to end.
Nor is the continued default by cities, states, unions, and mega-corporations on defined-benefit plans, which were largely instituted before the age of the 401(k). According to Institutional Investor’s aggregation of pension statistics, the funding shortfall for current pension plans is between $500 billion and $3 trillion. The precise figure depends on whether or not you include the cost of all those lifetime health benefits. Therefore, the trend of companies shedding pensions in bankruptcy and states reducing benefits to balance struggling budgets will likely continue.
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