Am I on track for retirement?
In a nutshell
An essential missing element from DC plans is a feedback loop which at least annually gives you an indication of whether you are on track to your planned retirement date and income level. Wade Pfau, whose work on safe savings ratesI reviewed a few weeks ago, now tackles the problem “Am I on track for retirement?’ using historical U.S. market performance context, worst case outcomes and using a targeted income replacement rate whose value is then adjusted annually for inflation.
This is no doubt a question that many working individuals ask themselves periodically. In a new blog I just got from Wade Pfau “Getting on track for retirement”, he tackles this question from the perspective of three key assumptions: historical market performance, worst case scenario point of view and assuming that upon retirement one has to cover expenses to age 100 using using a targeted income replacement rate in year one then adjusting its value annually for inflation to maintain real buying power. The independent variables are savings rates, accumulated wealth, asset allocation (percent stocks, S&P500 allocation, in the U.S. investor context) and income replacement rate.
In the blog, Pfau provides three tables (that you might be interested in examining) which suggest historically based worst case retirement ages for each of 35, 45, 50 and 60 year olds. The results are fascinating, keeping in mind the assumptions going into the calculations (and Richard Hamming’s admonition that the purpose of computing is insight not numbers) for the insights that you get from the results.
First of all, based on Pfau’s data (his 50% replacement rates and zero accumulated wealth case) I compiled another table which shows the sensitivity of historical worst case remaining years to retirement as a function of the Saving rate (SR) (sensitivity= years of earlier retirement per 1% increase saving rate).
What the table shows is that depending on one’s age the for each 1% increase in savings rate you advance retirement age by 0.6-0.73 years.
So bottom line for some of the insights from Pfau’s results, might be:
1. Advancing “safe” retirement age requires special effort; each 1% increase in savings rate only advances retirement age by about 0.7 years, more or less independent of the age profile looked at, increasing savings rate from 10% to 25% (only) advances retirement age by around 9-11 years. (Also, it’s hard to beat the power of compounding; i.e. the old saying about investing that what counts is not timing the market, but time in the market. Furthermore, not discussed in the blog, is the other benefit to increasing savings rate, which is getting used to a lower spend-rate (standard of living) during working years will make it that much easier to maintain/replace that standard of living in retirement.)
2. When you look at the second of the three tables he provides for each age profile, you note that you achieve lower/earlier predicted worst case retirement age as you increase the stock allocation 0% to 50%, but you advance retirement age only by about one or two years when you increase stock allocation from 50% to 100%. So one’s first reaction might be that there is little point in taking more risk than 50% stock allocation. However upon further reflection (confirmed by correspondence with Pfau) the table might be interpreted to also suggests that, since these ages are worst case retirement ages, and at least historically there was little risk (about one or two years) to worst case retirement age (for a given income replacement ratio) by increasing stock allocation from 50% to 100%. This might seem counter-intuitive, but remember that this doesn’t mean that you might not lose a very large amount of money in any one year with a market swoon (perhaps even in the year of your retirement), it just means that historically you can still achieve the target income replacement rate (i.e. your downside was essentially ‘fixed’ historically but your upside was larger with a higher stock allocation, in the U.S. market. However the pain associated with a market swoon, given a 100% equity allocation, in terms of reduced wealth will still be significant. You might also wish to read my earlier Time Diversification blog.)
3. The most effective way to increase retirement income is by delaying retirement; you gain about 5% additional income replacement for each year of delayed retirement. (Look at the third table for each age profile; independent of level of wealth there is a about a two year difference for each 10% pickup in replacement rate.)
4. This type of analysis is especially critical and is typically a key missing feedback element from DC plans and their regular accompanying reports to participants. An annual indicator of expected and/or worst case retirement year(s) for some desired level of retirement income, given one’s current assets, savings rates and asset allocation, is a necessary feedback loop to allow each individuals to better understand the answer to the question: “Am I on track for planned retirement?”
I have always been uncomfortable with looking at retirement income as some “income replacement rate”, instead of looking at meeting some projected retirement spending level based on actual pre-retirement spending adjusted for expected/desired spending puts and takes on top of that base (i.e. perhaps a expenditure/life-style replacement rate), the reader could factor that into the target income replacement rate.
Wade Pfau answers the question “Am I on track for retirement?” with the historically resulting worst case retirement age based on assumptions of historical performance, worst case outcomes and a target income replacement rate adjusted annually for inflation until age 100. While the future will not unfold identically as the past did, the answer is key feedback element for all DC plan participants. His results indicate that historically it was not that risky to increase stock allocation well in excess of 50%. Advancing retirement age is difficult by increasing saving rate (though higher savings rate will likely also reduce required retirement income). You might consider bearing a little more risk, especially if you are not just worried about minimizing the downside, but also would like to maximize the upside (retirement lifestyle and estate). Delaying retirement is the most effective way of increasing retirement income (work and save for another year). Pfau’s results give us fresh insights, but you must remember that results are based on the assumptions of historical U.S. market performance, worst case outcomes and target income replacement rate annually adjusted for inflation for a stable buying power to age 100.
P.S. Many thanks to Wade Pfau for bringing to my attention some misconceptions of his approach in an earlier version of this/my blog. All remaining misconceptions are mine alone.