The Center for Retirement Research at Boston College recently came out with a new analysis of how much Americans need to save in order to be able to maintain a reasonable lifestyle in retirement. Published in November 2011, the report is titled “How Much to Save for a Secure Retirement.”
The study starts with an assumed target “replacement rate” that represents the fraction of pre-retirement income that an individual will be likely to need to maintain their lifestyle in retirement. A long-term project at Georgia State to estimate required replacement rates provides the numbers that serve as the foundation of the CRR paper. The Georgia State research suggests that households with income from $50,000 to $90,000 will need about 80% of their pre-retirement income to sustain them in retirement (including Social Security).
The analysis first estimates the amount of income that people at different income levels can expect to receive from Social Security. As a number of studies have discussed, Social Security covers a smaller fraction of expected income in retirement for people with higher incomes than for people with lower incomes. Another important baseline assumption is that investors will receive a real rate of return (e.g. net of inflation) of 4%. With 3% annual inflation, the total return would be 7% in a year, for example.
I will highlight a few of the study’s findings:
- A medium earner who starts saving at age 25 needs to save 15% of his income in order to retire at age 65 with an 80% income replacement rate.
- The same medium earner who starts saving at age 35 needs to save 24% in order to retire at age 65 and 18% to retire at age 67.
- A high earner who starts saving at age 25 needs to save 19% to be able to retire at age 65 and 16% to be able to retire at 67.
- The high earner who starts saving at age 35 will need to save 30% to retire at age 65 and 25% to retire at age 67.
Conclusions to Be Drawn
The study shows, not surprisingly, that the key behaviors for investors are (1) to save aggressively, (2) to start saving earlier, and (3) to work longer. Even starting saving early and working later in life, the required savings rates that result from this analysis are vastly higher than what Americans are currently saving. As of 2010, the average savings rate of workers in 401(k) plans is about 7%. Data on investors without company-sponsored retirement plans are likely to be lower.
The research on required replacement rates, while commonly cited, is not unanimously accepted as a reasonable basis for projecting savings rates. Laurence Kotlikoff, a professor at Boston University, is an outspoken critic of the ‘replacement rate concept’—he refers to the use of replacement rates for retirement planning as ‘financial malpractice.’ Kotlikoff’s alternative approach to estimating necessary savings rates suggests that the 80% target replacement rate is simply too high and requires unnecessary sacrifices earlier in life. Having read Kotlikoff’s critique of the replacement rate concept in his book (co-written with Scott Burns) Spend Till The End, I remain convinced that the basic idea is valid, although there is plenty of room for debate on what the target replacement rate should be. Another potential problem with this analysis is the assumption of 4% real returns. Over the 20-year period from 1988-2007, investors in 401(k) plans managed to achieve an average annual return of only 4.48%.
In this same period, the S&P 500 returned an average of 11.8% and T-bills returned 4.5%. The poor returns in 401(k) plans are largely attributable to bad timing decisions: investors tend to buy high and sell low. The average rate of inflation over this period was 3.1%. Investors generated real returns of only 1.4% per year, far below the 4% real rate of return that the CRR study assumes as its baseline.
So, What Now?
We find ourselves in a situation that looks disastrous. American workers are saving far less than the CRR suggests they need to, but the CRR study assumes baseline returns that are much higher than investors have been able to achieve. The CRR study does look at how their estimates will change based on returns that are achieved. Our medium earning worker who starts saving at age 25 will need to save 28% or her income if she gets a 1% real return and 23% if she gets a 2% real return. Using the last twenty years as a guide, with the average investor achieving 1.4% in real return, our hypothetical medium earner would need to save around 25% from age 25 to age 65 in order to retire at age 65. Yikes.
So do these results mean that many, if not most, Americans will never be able to retire? Given current savings rates and the terrible historical performance of individual investors, this would not be an unreasonable assumption. On the other hand, it is entirely possible that people will simply retire into considerably reduced financial circumstances, either by choice or because of health issues or poor job prospects.
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