One of the big questions that faces today’s Baby Boomers (as well as anyone that plans to retire in the future) is how much of a nest egg is needed to fund one’s retirement? Given the increasing usage of high cost drugs, the extremely high cost of long-term care and increasing longevity, this issue is of great importance. A recent analysis by David Blanchett, Michael Finke and Wade Pfau gives us a good sense of what we have to save to fund a retirement, particularly this ultra-low interest rate environment.
Those of us that invested during the decades from 1970 to 2000 became quite accustomed to returns in the double digits; in the case of U.S. equities, between 1951 and 2000, stock prices grew at 5.89 times greater than the growth in dividends, a marked change from the period between 1875 and 1950 when stock prices rose in tandem with dividends and earnings. The authors term the rapid growth in stock prices in the decades up to the year 2000 as “excess capital gain”. This unsustainable growth in equity prices has created an atmosphere where investors expect future returns that are inconsistent with the actual returns that equities can provide at current valuations; in other words, one of two things will have to happen:
1.) equities will either have to fall by more than 50 percent in order to maintain their historical equity premium or
2.) investors will need to get used to a lower return on their equities in the future.
The authors state that in the current environment, it has become significantly more expensive to buy investment income than it was in the past, particularly since there are high valuations on risky assets (i.e. equities and earnings) and low yields on safe assets (i.e. bonds). Here is a graphic showing how the cost of bond, dividend and earnings has changed since 1955:
Here are some examples:
1.) Interest income from a ten-year Treasury Bond – average price to buy $1000 in interest income since 1927 is $19,802; today, that same $1000 in income costs an investor $63,694.
2.) Corporate earnings – average price to buy $1000 in corporate earnings since 1881 is $16,671; today, that same $1000 in corporate earnings costs $27,812.
In the case of the Treasury Bond, the historical average interest rate is 3.5 percent; if interest rates on the ten-year Treasury were to rise from their current level to the historical average, the value of the bond would fall by 17 percent. This means that, either way, Treasury investors will have to face the consequences of today’s ultra-low interest rate environment.
Obviously, an environment of low returns on investments increases both the percentage of income that a household needs to save for retirement as well as reducing the income that a household will receive once their savings goal is reached. To reach the same level of retirement spending provided by $750,000 in savings (leaving behind a $500,000 legacy) at a 6 percent real return, households would have to save about $1 million in a 2 percent real return world.
Now, let’s get to the meat of the matter. Let’s look at the author’s Savings Simulation Model which estimates the required savings rate needed to maintain the same level of after-tax pay during retirement as the final year before retirement which begins at age 65. All savings are assumed to be pretax (i.e. 401(k) or IRA. While, in general, the income replacement level (i.e. the comparison between pre- and post-retirement income) is less than 100 percent since retirees tend to decrease spending during retirement, actual household spending levels during retirement vary widely and, in fact, may grow in the later years of life when retirees avail themselves of assisted-living arrangements.
1.) “low returns” have real bond yields of 2 percent that remain at this level and “moderate returns” have real rates of return that rise slowly over time.
2.) savings rates would increase by approximately 25 percent over 10 years.
3.) improvements in life expectancies are used to estimate the retirement period, for example, retirement for a person that is currently 25 years old is likely to be longer than retirement for a person that is currently 65 years old.
4.) higher income households are likely to have longer lives than their lower income counterparts.
As you can see, the longer than households wait to save for retirement, the higher the required savings rate becomes. For instance, a joint household with income of $100,000 would have to save 19 percent of pre-tax income annually in a low return environment and 16.5 percent in a mid-return environment whereas, at 25 years of age, the same household would have had to save 12.5 percent and 9.7 percent in low- and mid-return environments respectively. There is one escape from this; by postponing retirement from age 65 to 70, for example, the optimal savings rate decreases as shown here for a couple that starts to save for retirement at age 35:
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