The chart below shows that a future retiree faces a wide variety of outcomes based solely on the investment returns achieved during the sixty-year span of accumulation and withdrawal. For example, if a member of the 1918 cohort saved 16.62% of her income for thirty years and replaced 50% of her final salary for thirty years, she left nothing to her heirs. Contrast this with a member of the 1966 cohort who did the same, but left her heirs 8 times her final salary after 30 years. This underscores the fact that the saver faces a very uncertain future with a wide possibility of outcomes. The “safe” savings rate is based upon the worst possible historical outcome so you hope that your generation does not create a new outlier to the downside!
Image source: http://www3.grips.ac.jp/~wpfau/images/safesavings_wealth.jpg
The study, Safe Savings Rates: A New Approach to Retirement Planning Over the Life Cycle, estimates “safe” savings rates that historically provided a retiree enough money to replace either 50% or 70% of her final salary. The author makes several notable assumptions: (1) the individual earns a constant real income, (2) the portfolio consists of large-capitalization stocks (“equity”) and six-month commercial paper (“bonds”), (3) there are no portfolio management fees, and (4) income taxes are not considered. These assumptions make a strict adherence to the “safe” savings rates in Table 1 of the study impossible so understanding how these assumptions create potential understatements or overstatements to the “safe” savings rate is important.
First, most workers do not earn a constant real income. A constant real income consists of an initial salary that is adjusted for inflation each year. If this were true, the employee would never receive an increase in salary due to a raise or promotion, for example. A typical wage earner sees a sharp increase in salary from the mid-20’s to the early 40’s, then a flattening out from there. There is also the issue of maternity leave leaving a sizable gap for women who choose to stay at home with their children. Consequently, this study may understate the amount of savings needed in the early years to produce the required 50-70% of the final salary.
Second, a portfolio consisting of only large-capitalization stocks and six-month commercial paper may provide a lower annualized rate of return than a diversified portfolio that includes small capitalization and international stocks among other asset classes. See The Ultimate Buy-and-Hold Strategy for an example of the possibility of increasing portfolio returns by diversifying into more than two asset classes. By using only two asset classes, the study may overstate the “safe” savings rate if a more diversified portfolio outperforms the two-class portfolio used by the author.
Another thing to keep in mind regarding portfolio construction is one’s individual tolerance for risk, which in this case means volatility. The study uses two portfolios: a 60/40 and 80/20 equity and bond mix. See Fine Tuning Your Asset Allocation for a table of historical annualized return, standard deviation, worst month, worst 12-months, and worst 60-month results for a given portfolio weighting. It is important to be honest about your risk tolerance rather than focus on the smallest “safe” savings rate. Likewise, one’s risk tolerance may change during the accumulation period; the study does not take a change in risk tolerance into account. An 80/20 equity and bond mix through the accumulation and retirement phase is flat out unlikely so the 60/40 equity bond mix numbers appear more appropriate.
Third, the study does not consider portfolio management fees. Retirement investors typically run into the following portfolio management fees: commissions, mutual fund management fees, ETF management fees, and concession fees paid for the purchase of individual bonds. These fees may cause the savings rate to be understated. The author estimated that omitting portfolio management fees may cause an understatement of as much as six percentage points if a 1% annual portfolio management fee is deducted each year so keep your fees as low as possible. There are many fee based planners that charge hourly rates that may make more sense than an annual fixed fee.
Finally, income taxes may change the “safe” savings rate depending upon the type of retirement vehicle used by the saver. Using tax advantaged accounts provided by the government is important. Higher marginal tax rates during retirement than the accumulation period may also require a higher “safe” savings rate.
As with everything concerning uncertainty, this study is not perfect. However, it does provide a useful framework. The framework requires three steps to quantify an appropriate “safe” savings rate: (1) determine the percentage replacement rate of your final salary that you wish to target, (2) choose an appropriate asset allocation, and (3) estimate the number of years that you expect to work and retire.
The author also published a similar study that shows how much to save if you have already accumulated a substantial retirement fund. The study, Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work, provides tables for 55 year-olds. Additionally, Pfau's blog post entitled Getting on Track for Retirement provides tables for 35, 45, 50, and 60 year-olds.
