Retirement planning is for old people. Until then we can merrily skip through life singing that old Roman hit “Carpe Diem”. According to the Center for Retirement Research (CRR) at Boston College, too many people have adopted that happy-go-lucky approach. In a 6/5/09 WSJ op-ed, Janice Nittoli, a vice president at the Rockefeller Foundation, presents some sobering survey data.
The CRR calculates that 61% of workers are not saving adequately. At the end of 2007, the average 401K balance was under $19K. That was before the severe dip in equity prices last September. What about the boomers who will start retiring in the next few years? The median retirement savings for workers aged 55 – 65 was less than $100K. Again, that was before the recent downturn.
Ms. Nittoli writes “A full third of U.S. employers have reduced or eliminated their matching contributions to retirement accounts since January of last year and another 29% plan to do so before  is over.” In a downturn like this, companies reduce employee benefits. This contribution reduction comes at a time when equities are priced at historical lows. In effect, 401K plans can lose the benefits of dollar cost averaging, i.e. buying more when prices are down, buying less when prices are up.
There are many online retirement calculators that offer to tell you whether your savings are on track for retirement. Unfortunately, there can be a wide difference of opinion in these calculators. They often seem like black boxes requiring a person to input a few variables, then magically spitting out an answer like “You will need $1.5 million in savings to retire.” Upon hearing this we may be tempted to go down to the nearest karaoke bar, get drunk and sing “Carpe Diem.”
A more concrete way to understand your financial future might be to look at an annuity calculator. For our example, we will use a type of annuity called an immediate fixed annuity, which is a contract with an insurance company, for example, where you give them a certain amount of money and they pay you monthly or annual amounts for a set period of time. This is not a recommendation to buy such a product, only an example to estimate the health of your saving plan.
Let’s say you are at retirement age and you figure you need to net $3000 a month to meet your expenses. You figure that the Social Security Administration (SSA) will take about 10% income tax out of your $1500 a month social security check, leaving you with $1350. In this example, let’s say that any Medicare B or other health insurance premium is already included in the $3000 per month expense figure. I’ll also assume that you don’t have any other fixed pension plan. So, you need an extra $1650 a month, or about $20K annually, to meet your expenses.
The key component in using these calculators is the percentage rate of growth or, in our example, the interest rate of the annuity. Federal Reserve data shows that the rate of return for 10 year Treasury bonds has been 5.4%. Using the calculator at a slightly more conservative 5% growth rate, you find that you would have to have an annuity of about $250K to get the payout you need over the next 20 years. So, is that your answer – $250K? Not quite.
Your $3000 monthly expense will grow larger with inflation, which has averaged 3.1% over the past 80 years. Your social security check will grow with that inflation rate but the “extra” you needed every month won’t. As the cost of living increases, that extra amount of $1650 that you need to cover this year’s monthly expenses will grow to be $3036 per month in 20 years.
A more realistic percentage rate of growth is to subtract the historical rate of inflation, 3.1%, from the historical rate of return on a 10 year Treasury bond, 5.4%. The result is 2.3%. Subtract from that about .4% of the return for the income taxes you’ll pay on the interest your money will earn and the result is about 2%. Putting that percentage into the calculator gives a result of $327K. That’s a more realistic minimum savings goal and one that, given the survey data, a majority of workers will have difficulty meeting.
While $327K sounds like a lot of money, a person aged 25 who saved $200 a month in a savings account paying 5% would have that approximate amount at age 65. When Einstein was asked what was the most powerful force in the universe, he replied “Compound interest.”