Portfolio 10

So Just How Much Should You Be Saving for Retirement?

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Portfolio 10

This, of course, is a crucial question to both your current and future financial security. Certainly, there are no easy “one-size-fits-all” answers, but thanks to some recent research ("Income-Based Savings Rates") from Massi De Santis and Marlena Lee of Dimensional Fund Advisors (DFA), we have gained some helpful insights into this extremely complex issue.

Using income data for 100,000 households from the University of Michigan’s Panel Study on Income Dynamics (PSID), De Santis and Lee simulated the impact of income, asset allocation, savings rates, and age on retirement outcomes. Rather than simply calculating on the value of investments at retirement, De Santis and Lee focused on the real income (i.e., an inflation-indexed annuity) that could be purchased, the percentage of final salary this income would replace, and perhaps most importantly, the probability of achieving this goal.

Regarding desirable replacement rates of preretirement income, Marlena Lee studied that question last year (using the PSID data) and produced the following table:

Table 1: Recommended Income Replacement Rates

As you can see, a higher income at retirement requires a lower replacement rate, because spending tends to decline with age, households tend to pay less tax in retirement, and saving for retirement is no longer required. Furthermore, at lower incomes, Social Security plays a larger role in income replacement, which is exactly how the Social Security system was designed. Calculating scenarios for a worker who is well into the top quartile, Lee and De Santis assumed a target replacement rate of 40% after forty years of saving from age 25 to 65. They looked at three different types of asset allocation. The first was a glide path allocation (which they called a “trend allocation”) with a declining equity exposure over time equal to 120 minus age. The second allocation was a static 60/40 equity/fixed income allocation. The third allocation was designated as “nonlinear” and was 100% equities until age 40, declining equity exposure (by 2.5% per year) until age 60, and then a static 50/50 equity/fixed income after age 60. In all cases, the equity side was represented by a global equity market portfolio and fixed income was represented by 5-year Treasury bonds.

A result that many would consider surprising is that asset allocation methodology has a relatively small impact on the required savings rates (expressed as a percentage of income). Of the three allocations described above, the largest difference in the savings rate required to achieve a 95% probability of replacing 40% of preretirement income was only 0.4%, and this small difference appears to be entirely explained by the overall difference in equity exposure among the three methods. The lesson learned from this is that the asset allocation itself is not as important as maintaining a consistent approach. Specifically, one should not vacillate among different asset allocations based on market conditions.

Digging a little deeper into the numbers, with a glide path allocation, a 16.8% savings rate is required to achieve a 40% replacement rate with a 95% probability. The median replacement rate in this scenario, however, is 130% indicating that the worker over saved, and although he is likely to have a surplus in retirement (and a windfall for his heirs), it came at the cost of forgoing consumption during his younger years. Perhaps he missed out on a trip to Paris or the possibility of driving a much nicer car? Either way, most of us would agree that it is better to have too much money in retirement than too little, even if it comes at the cost of sacrificing luxuries during the working years.

 A result that should surprise no one is that starting early in retirement, saving is vital. For the 25-year old saver described above, if he were to start at age 30, his required savings rate would be 19.5% instead of 16.8%, and if he were to start at age 35, it jumps to 23.8%. Workers who are over age 40 and have not started saving for retirement are on course for what is shown below:

Unfortunately, the train wreck metaphor is all-too frequently invoked to describe the future of the U.S. retirement system where the average amount of savings is about $65,000 for those aged between 55 and 64 (according to the Employee Benefit Research Institute). One important variable studied by De Santis and Lee that may partly explain the under savings problem is income path. It is quite rare that somebody has exactly the same real income throughout his career. For most workers, their real income increases as they learn more skills and become more valuable to their employer. Unfortunately, an increase in real income requires an increase in the savings rate if the goal is to replace a set portion of final preretirement income, and most workers do not increase their savings rate as their income increases. De Santis and Lee produce the following table of graduated savings rates that result in a 95% probability of replacing 40% of preretirement income.

Table 2: Required Savings Rate to Replace 40% of Preretirement Income with a 95% Probability (25-year-old retiring at age 66 following a glide path allocation)

To gauge whether a worker is on track to meet her retirement goals, De Santis and Lee examine the ratio of retirement assets to income. For a 35-year-old (who, in theory, should have been saving for ten years) the additional savings required on top of the percentages in the above table are as follows:

Table 3: Additional Savings Rate on Top of Table 2 Rates Based on Accumulated Retirement Assets for a 35-Year-Old Worker

For example, if our 35-year-old worker has $175,000 of retirement assets and a current income of $100,000 then she can continue to save according to the percentages in Table 2. If, however, she only has $100,000 of retirement assets, then she would need to add 2% to the values in Table 2.

The final sentence of De Santis and Lee’s conclusion is very important: “While outside the scope of our study, asset allocations that actively reduce upside potential as the probability of reaching income replacement goals increases may help lower overall savings rates.” This is the approach of DFA’s Managed DC program for 401(k) plans. Below are three videos produced by IFA.tv that explain the underlying philosophy and methodology of Managed DC.

A New Look - Show 41-3

Shifting the Conversation - Show 41-2

Ready-Set-Retire - Show 41-1

To determine if your retirement savings are on track, please check out IFA’s Retirement Plan Analyzer. For more information about Managed DC and how it can improve your 401(k), please contact IFA’s Retirement Plan Services at 888-643-3133 or obtain a retirement plan scorecard from ifa401k.com.