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Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.

No time like today to save for tomorrow – Part 2

In my last post, I talked about the importance of making good financial decisions when planning for retirement. Although people have good intentions about how and when to save, left to their own devices, they fall prey to certain biases when making financial decisions. In this article, we’ll address additional obstacles and introduce some solutions to work around these issues.

Procrastination. Closely associated with self-control, procrastination is the tendency to postpone unpleasant tasks. Instead of engaging in a goal-achieving activity such as retirement planning that involves complexity and may lead to frustration, people often opt for a stress-relieving activity such as watching a favorite television program. Herbert Simon, another Nobel Laureate related procrastination to “cognitive laziness” which is the attempt by individuals to avoid the hard work of thinking through a problem.

 Inertia. Procrastination in turn produces a related psychological force known as inertia, which is the resistance to change. This resistance often is the consequence of what is known as “loss aversion”. This is the tendency of decision-makers to put more emphasis on what they could lose rather than how they might benefit. A key finding of behavioral economics is that people weigh losses significantly more heavily than gains. Some estimates peg the ratio at 2:1. In other words, losses generate twice as much psychological pain as gains yield pleasure.

Loss aversion affects saving decisions because once households become used to a particular level of take-home pay, they tend to view reductions in that level as a “loss”, even when it is the result of increased savings. Compounding the challenge, saving for retirement involves a difficult trade-off between current and future consumption. The evidence is clear that most individuals have a strong preference for the immediate rewards of spending today over the future payoff of enjoying an increased standard of living in retirement.

Solutions:

Fortunately, the study of the behavioral forces that result in poor decisions has enabled researchers to develop strategies to employ those forces to produce better choices and financial outcomes. A program designed by behavioral economists Shlomo Benartzi of UCLA and Richard Thaler of the University of Chicago does just that. Their program called Save More Tomorrow (SMarT) is intended for employers who want to increase employee savings rates in 401(k) type plans. One feature known as “automatic escalation” however can easily be adapted by the average person saving for any important future goal.

The idea is to automatically increase savings from the employee’s paycheck with each future salary increase. This simple tactic can avoid the psychological barriers that impede individuals from achieving what they want; minimum pain today and larger account balances at retirement. It uses what could be considered a “behavior first” approach meaning that it requires a change of behavior rather than a change of attitude or an increase in computational skills. These are some of the benefits:

  • It’s simple. It eliminates the complexity of making difficult assumptions and calculations. It is a yes or no decision. You either commit to it or you do not. Once committed, you know that 30%, 50% or more of each pay increase will be “swept” into an investment account. All of the calculations are complete, and the hard work is done.
  • It is pre-determined. Because of the psychological barriers of lack of self-control and procrastination, most of us find it easier to imagine and commit to doing something difficult in the future rather than right now. Pre-commitments are a way of avoiding the inevitable temptation of the moment (when the cash is in our hands), and our inclination to procrastinate matters that have an immediate cost but a future reward.
  • It’s painless. Inertia can be triggered by several factors, one of which is hypersensitivity to loss, or placing more weight on the pain from the potential loss than the benefits from the potential gain. In the savings context, people hate to see their take-home pay go down. The automatic increase program does an end-run around these powerful psychological forces. In their book “Nudge” authors Richard Thaler and Cass Sunstein applaud the success of the SMarT program in general and the automatic escalation feature specifically. “By synchronizing pay raises and savings increases, participants never see their take-home amounts go down, and they don’t view their increased retirement contributions as losses. Once someone joins the program, the saving increases are automatic, using inertia to increase savings rather than prevent savings.” Simply put, it is easier to keep on doing what you have been doing, than it is to change.

Behavioral economists have identified the obstacles humans face when making financial decisions involving complex problems surrounded by uncertainty and require an immediate sacrifice for an uncertain payoff in the distant future. That is to say, precisely the elements households face in planning for retirement. As humans, we fall prey to a combination of psychological forces that lead us to make poor choices.

Fortunately, the same factors that hinder individuals from making wise choices are now being employed to help people improve their chances of securing a comfortable retirement. Committing to save a substantial portion of future pay increases is one of the simplest and most effective strategies to do this. It does not require superior skills or an advanced degree, just a little common sense – and yes, also some self-control.

No time like today to save for tomorrow – Part 1

A long, healthy life is a blessing. The good news: Americans are living longer than ever before. Life expectancy has increased dramatically in the last few decades as a result of major advances in science, technology, and medicine. An individual’s life expectancy is his or her median lifespan. In the United States, the life expectancy of a 65-year-old male non-smoker is 20 years. This means that 50% of men are expected to live beyond age 85, and 50% are expected to die before 85. A 65-year-old non-smoking woman on average is expected to live until age 88. When combined with the life expectancy of a spouse, the odds are 50% percent that at least one spouse will live to age 92 and 20% of living to 98.

Even better news: life expectancy statistics reflects averages for the entire U.S. population including those with serious medical conditions, poor lifestyle habits and limited access to quality medical care. I suspect that few readers of this newsletter would be representative of the overall population. In other words, most of us can expect to enjoy a lifespan somewhat greater than the statistics indicate.

Because a particular individual’s lifespan is unknown, smart retirement and investment decisions require each of us to make reasonable assumptions about our expected life spans. Economists use the term “ longevity risk” to refer to the possibility that a person will live a longer or shorter life than expected. Because there are lifestyle costs associated with either overestimating or underestimating a person’s lifespan, it’s important to consider the implications of being wrong. In this case, planning overly-conservatively (that is, for a longer life) can result in an unnecessarily frugal lifestyle and squandering an opportunity to enjoy the money while your health is good. On the other hand, planning for a lifetime that is too short can mean overspending and depleting your savings prematurely, resulting in a reduced standard of living or dependence on family or friends. The latter error would strike most families as carrying greater risk. In light of that, while it can make sense to use a shorter life expectancy in certain situations where an individual’s health is clearly failing, in most cases the more prudent approach is to assume a planning horizon through age 95 or 100.

However, this longer life requires us to prepare physically, intellectually and financially in order to avoid living a decade or more impaired and impoverished. More money is needed to sustain a longer lifespan, and this changes the calculus of Americans’ retirement decisions. Unfortunately, there is little evidence that this is happening. According to a recent survey conducted by the Society of Actuaries (SOA), pre-retirees and retirees underestimate the probability that they or their spouse will live into their 80s, 90s or longer. There are obvious risks for those who fail to appreciate and adapt to this new reality.

In my next post, I’ll talk about those risks.