(Submitted by Elozor Preil) Just because you have a plan doesn’t mean it will work.
An integral feature in many personal financial programs is a projection of future accumulations, and the retirement income this accumulation could provide. This projection is derived from a combination of the number of years to accumulate and de-accumulate, the amount of money either deposited or withdrawn and the rate(s) of return that will be applied to those amounts.
A change to any one of these variables impacts the projection. Of the three (time, money, rate of return), the rate of return is the easiest to tweak, and the easiest to abuse. A person’s current age and life expectancy put parameters on the time aspect of the projection, and amounts that have been accumulated or can be added reflect your financial history. But projecting a rate of return? There’s an Alice-in-Wonderland aspect to it. To paraphrase Humpty Dumpty: “When I select a rate of return, it is as realistic as I say it is.”
Rate of return is a projection bail-out. If you’re not saving enough, assuming a higher rate of return can make up the difference. If you haven’t accumulated enough, a higher rate of return can produce more income from a smaller balance, or make it last longer. But in real life, pursuing a higher rate of return typically entails more risk, which also increases the potential for plan failure.
To prevent a Humpty Dumpty use of rates of return in projections, financial professionals have compiled comprehensive studies of historical returns to determine “realistic” rates of return. When you restrict rates of return to a narrow range of realistic possibilities, you can derive some benchmarks for what individuals need to accomplish in their financial plans, and what they can expect from their efforts.
The Safe Withdrawal Rate
In 1994, using research on historical returns and retirement scenarios from the previous 75 years, California financial planner William Bengen determined that retirees who drew down no more than 4.2 percent of their portfolio in their first year of retirement, and adjusted that amount for inflation in subsequent years, would, under almost all circumstances, not outlive their money. Further studies have reaffirmed Bengen’s initial analysis, and the “4 percent rule” has become a benchmark frequently used for the distribution phase of the planning process.
The Safe Minimum Saving Rate Matrix
While the 4 percent rule can suggest how much an individual might safely spend each year from accumulated savings, it is arguably more important to arrive at an adequate rate of annual savings.
In the preface to a 2011 white paper, Wade D. Pfau, Ph.D., a Tokyo professor with a doctorate in economics from Princeton University, articulated the importance of determining, and maintaining, a rate of saving that would deliver enough money at retirement under all scenarios:
“The focus of retirement planning should be on the savings rate rather than the withdrawal rate… Starting to save early and consistently for retirement at a reasonable savings rate will provide the best chance to meet retirement expenditure goals. Actual withdrawal rates and wealth accumulations at retirement may be treated as almost an afterthought in this framework. The savings plan should be adhered to regardless of whether it seems one is accumulating either more or less wealth than is needed based on traditional criteria.”
In an analysis of investment returns from 1871 to 2009, Pfau calculated a “safe savings rate.” This was the percentage of one’s income that would need to be saved each year to provide a sufficient retirement income (using the 4 percent safe withdrawal rule) across every historical period.
Pfau assumed a “sufficient” annual retirement income to be 50 percent of an individual’s last year of earnings while working. He also assumed the individual would begin saving at 35, save for 30 years, and live 30 years in retirement. Thus, a 65-year-old earning $150,000 in the year before retirement would need to accumulate $1.875 million to provide a $75,000 base retirement income.
Pfau concluded a savings rate of 16.62 percent of annual income was the minimum percentage that could be expected to deliver satisfactory results over every 30-year accumulation period.
Because not everyone retires at 65, or begins saving at 35, Pfau also produced a matrix of “safe saving rates” for different accumulation and retirement periods.
The matrix brings several conclusions into stark focus. First, a delay in saving creates a huge challenge to a successful retirement; those who don’t begin saving until their late 40s and 50s have a daunting annual savings requirement to secure sufficient retirement income. And second, if savings are deficient, the most realistic adjustment (as opposed to increasing the rate of return) is to plan on working longer.
A deeper dig into Pfau’s study reveals two additional nuggets:
- Taking more or less investment risk has limited impact compared to an increased saving rate. Pfau’s matrix used historical rates of return from a mixed portfolio of investments. But he also developed similar matrices for riskier and more conservative investment mixes. Using the same 30-30 scenario, a more conservative portfolio required a safe saving rate of 19.33 percent while a riskier portfolio needed a 15.14 percent annual saving rate.
- To be consistent with other research, Pfau did not take into account any fees that might be incurred as a result of owning particular types of assets, “but simply introducing a fee of 1 percent of assets deducted at the end of each year would increase the baseline scenario’s safe savings rate significantly from 16.62 percent to 22.15 percent.”
Facing Retirement Reality
Essentially, Pfau’s numbers say that if you’re not saving at least 15 percent of income by age 35, your retirement prospects will be delayed, diminished or uncertain. You can try to craft a different narrative using Humpty Dumpty rates of return, but imaginary numbers aren’t a recipe for realistic results.
In light of this sobering perspective, establishing a healthy saving plan should be the number one priority in almost every financial program. Waiting to save—until student loans are paid, until you have a house, until the kids are in school—makes the catch-up percentages almost impossible. If you’re under 30, you should make 35 the absolute latest date for getting your saving rate where it needs to be, and making sure it can stay there for a long time. If you can get there sooner, all the better. If you’re over 50, catching up is a daunting task, but not impossible. You’re most likely to be in your peak earning years, and if you’re willing to tweak your current standard of living, it may be possible to save 30-35 percent of income from now until retirement. In between 30 and 50? You probably have a good idea whether you need to aim for a higher percentage or just continue with what you’ve been doing. And consider whether working longer would be beneficial or possible.
The Right-Now Importance of Cash Flow Management
Cash flow management, the ability to arrange your personal finances so that robust saving is possible, is a fundamental that must be mastered to achieve your financial objectives.
Yet advertising from most financial institutions says very little about the critical role of saving. Instead, there’s encouragement to find your “number,” the amount you’ll supposedly need to retire. Or a blurb touting a superior return on savings in a particular strategy or product.
But realistically, the most valuable financial professionals are those who can help you manage cash flow and save more. Whether it’s tax deductions, lower insurance costs, reduced interest rates, discounted fees, refinanced debt or simply pointing out “you need to save more,” any guidance or transaction that redirects current cash flow to savings will be your most profitable financial activity—at any age.
This article was prepared by an independent third party This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
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