I’ve written ten posts in this series about lifetime financial and retirement planning so far, and have yet to talk about how to invest your savings.
I could say in a word, “carefully,” but there’s much more to it than that. It starts with understanding what investing is, why you should invest, and how it matches up with your lifetime financial plan, which is what we’ve been exploring here so far. Two recent articles are the occasion for this post on gaining a fuller understanding of the relationship between planning secure retirement income and investing.
The first thing many financial advisors (‘brokers’) want to talk about is investing. They are full of ideas for investing your money. They need to be—it’s how they earn a living. Nothing wrong with that, but it’s the wrong place to start. Even for many of those in the ‘high net worth’ segment, which was less than 5% of households in 2010, it pays to start with a lifetime financial plan first, and invest based on the plan, and not the other way around.
The financial industry’s investment-first approach can also be very costly. Brokers doesn’t earn a living today on trading commissions, not at ten bucks a trade. Instead, they capture your portfolio and charge you a fee of 1% to 2% of total ‘assets under management.’ That’s $10,000-$20,000 per million. Before you spend that kind of money on your money (!), you should have a very clear idea of what you’re trying to accomplish and how your investments will produce the expected outcome—beyond assurances that “stocks are the best way to increase your savings in the long run” or that “a balanced portfolio reduces your risks to a tolerable level.” Neither statement tells the whole story.
The Need for Financial and Investment Literacy
Retirement is the single largest and most important financial goal most of us have to manage, more important than housing and transportation, which typically are monthly expense items paid out of cash flow. In the last twenty years, the responsibility for managing retirement has shifted from experienced managers of defined-benefit pension plans to self-directed 401(k) and IRA retirement accounts. In this do-it-yourself pension era, financial and investing literacy is crucial to setting up a successful retirement. As a process that depends upon a lifetime of earnings, by the time you realize that you may have a serious shortfall, it may be too late to make a meaningful difference.
This short WSJ piece on financial literacy and the basics of investing skims the surface of a larger problem. Regarding better schooling of financial basics, fewer than 20% of surveyed K-12 teachers felt very competent with the subject and “one of the areas they reported feeling least competent about was saving and investing.”
Even those in mid-career with years of business experience may be over-confident in their ability to sort out the massive amount of often contradictory financial information and investment guidance that now overflows media and commentary. In another survey quoted in the article, two-thirds rated their financial knowledge as high, while only about half could correctly identify whether a single stock or a stock fund was a safer investment.
At their worst, investment companies profit richly from we-the-befuddled-muppets. At their best, they try to simplify complex ideas and hypotheticals into ‘rules of the thumb’ that everyday folks can use for planning. Even so, without some understanding of the assumptions underlying their calculations, even a simple guideline might turn out to be unsuitable for you.
Fidelity’s New Savings Guideline
Fidelity recently issued a new guideline that most people should save 8x their ending salary by age 67 to meet their basic retirement needs. The ‘old’ rule of the thumb was 25x estimated annual expenses net of SS + pensions for a retirement that could last 25-30 years. Apparently since most people have nowhere near this amount, Fidelity felt a “more achievable” rule of thumb would help more people get serious about retirement planning, and that it may be easier to work from an estimated final salary than from an estimated expense number.
On the face of it, this is a good thing. In the interest of financial literacy, here is a brief look at the assumptions behind this ‘new’ rule of the thumb, so you can evaluate more accurately what this guideline means to you.
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- The Fidelity guideline uses 85% of final income as its annual retirement funding goal, which in this case factors to $61,200. With rising healthcare and long-term care costs in retirement, this may be a low-ball–Fidelity explicitly excludes long-term care costs in its model. Or it might be too high if you are already saving a large chunk of your income (more than 20%) and living well within your means–good for you! You should make a realistic estimate of annual expenses in retirement expenses including healthcare expenses and long-term care costs. Estimated expenses in retirement is a more accurate planning tool than a percentage replacement income, since your goal is to fund those expenses. Much depends upon your desired retirement lifestyle. The difficulty if you are still 20 or 30 years from retirement is estimating either your final salary or your annual retirement expenses. Start by escalating your current salary and expenses by 3%/year for inflation, and make some adjustments for anticipated promotions and changed expenses in retirement.
- The guideline uses annual 1.5% raises from a starting salary of $40,000 at age 25, ending at $72,000 at age 67. It assumes continuous saving during that time, ramping from 6% a year at age 25, rising 1% annually to 12% annually after 6 years, with a 3% annual company contribution. This is 42 years of continuous employment, savings, and employer contributions. Have you ever been out-of-work for a significant period and drawn down savings? Has your company restored its 401(k) contribution yet after cutting it five or ten years ago? These factors may undercut the projected total savings expected prior to retirement, arguing for a larger savings percentage during your working years (the ‘accumulation phase’). You can estimate this for yourself and your spouse with a simple spreadsheet, a line for each year, plotting in increases for promotions as well as raises that offset inflation. With promotions, depending on your starting salary and you type of work or business, your final salaries may be much higher than that used in the Fidelity model, though the ratios and logic of the guideline still apply.
- The Fidelity model uses Social Security payments of $23,000 netted against 85% of the final salary of $72,000, which is $61,200 – $23,000 = $38,200. In other words, in this model savings will provide about 62% of estimated retirement expenses ($38,200), and Social Security provides about 38% ($23,000).
- The guideline assumes retirement age from 67-92, a span of 25 years. Your mileage may vary, one way or the other. Think about you and your spouse’s health and family factors that might affect your longevity.
- Fidelity uses a hypothetical average annual straight-line portfolio growth rate of 5.5% for the 40+ years of the accumulation phase, which is a reasonable estimate based on historical returns. There is much discussion today that forward returns may be as much as 1% lower for some time to come based on macro-economic factors, which would seriously impact the total amount saved at retirement. After 42 years of employment in the Fidelity model, $338,000 of contributions grows to $1,072,000, according to my spreadsheet with the Fidelity 5.5% annual straight-line escalator, and continues to compound during the 25 years of systematic withdrawal in retirement. While it makes calculation of projections simpler, this kind of straight-line compounding does not happen in real life.One year could be +15.5% and another -4.5% and still average to 5.5% annually. Left unspoken is market volatility and sequence-of-returns risk, ie, a string of losses that could decimate a portfolio, especially early in retirement when current income is required and there is little time to recover, an important reason to consider moving away from risk assets as retirement approaches.In real life, large gains usually follow heavy losses and may not make you whole (a loss of 30% in one year requires a larger gain of about 44% on the remaining smaller principal in the next or over several years to come back to even).
- The geometric average or, in finance, the compound annual growth rate (CAGR), is a more accurate way of measuring returns over time then a simple average growth rate. This random six-year sequence of returns, -25%, 20%, 9%, -2%, 19%, 12%, averages to 5.5%, and yields a 28.13% compound total return over the six period sequence. The CAGR for that total return is 4.22%, significantly less than the 5.5% simple average, which would yield a straight-line 37.88% compound total return over six periods. In the short sequence above, the CAGR total return is almost 10% less than the straight-line simple average total return.CAGR calculations aren’t available for projected returns. Fidelity opted to use simplified straight-line results for the guideline instead of more complex Monte Carlo simulations, which give a projected range of statistically probable results, to develop what they readily admit is a simplified rule of thumb. This is understandable. The bottom line, though, is the that the $338,000 of contributions may come up significantly short of the projected $1,072,000 over the 42 year period, which would impact the amount available for retirement income withdrawals.
- The withdrawal amount is not specified in the guideline, though 4% annually of portfolio value is generally considered a ‘safe’ amount for systematic withdrawal. In this case, 4% of $1,072,000 is $42,880, which covers the $38,200 balance of the 85% of pre-retirement income not covered by Social Security.
The wonderful thing about hypothetical average rates of return is that if you need to, you can always change them. For instance, in this case, a 4.5% average return instead of 5.5% would straight-line to $848,856, yielding $33,954 at a 4% withdrawal, which does not cover the $38,200. With a 4.5% average annual return, you’d need to save more, spend less, or maybe rationalize a higher rate of return.
What will the average return or CAGR be during your 40 years of accumulation? No one can say. Unfortunately, while the rate of return is hypothetical, retirement expenses are not. No one knows what future returns will be, which is why savings and investments need to be monitored and rebalanced throughout the accumulation phase. And why saving more is safer than saving less.
While looking at these assumptions, we’ve backed into some of the issues that surround retirement income based on systematic withdrawals from a portfolio of risk assets. Taking risk during the 4o years of accumulation can build your financial capital, while giving you time to earn and save more to make up for any losses that might result from a serious downturn.
In retirement, you do not have that luxury. Your savings are now dedicated to retirement income and any losses will impact that income, with little opportunity to make it up with new earnings for those no longer working. Lifetime retirement income planning looks at your personal balance sheet to determine how best to construct your retirement income portfolio to provide risk-free and low-risk income for essential annual retirement expenses. Anything above that income floor can then be used to build an upside growth portfolio consistent with your risk capacity–your ability to withstand losses.
The new Fidelity guideline of 8x final salary at age 67 (retirement age) provides a lower, cautionary boundary for savings. In their model, 8 x $72,000 is $576,000, which is 15x annual net retirement expenses of $38,000, at the lower end of the caution zone we use for gauging retirement readiness. When the straight-line 5.5% annual return is applied to savings during the 42 year accumulation phase, it grows to $1,072,000, providing a more comfortable upper range of 28x annual net retirement expenses. That’s also right in line with the ‘old’ rule of the thumb of 25x annual net retirement expenses. Even a 4.5% average rate of return will provide 22x annual net retirement expenses, based on the Fidelity guideline.
So the bottom line is that Fidelity’s 8x final salary savings guideline, if carefully invested, monitored, and rebalanced over 40 years to achieve at least 4.5% average annual return, has a high probability of providing a portfolio that can be converted to secure retirement income at retirement age to meet expenses equal to about half of your final salary (ie., 85% of final salary net of an ‘average’ Social Security benefit). As we’ve seen, much depends on the annual expenses you need to sustain your retirement lifestyle, along with other variables like Social Security, pensions, and your life-long earnings savings ratio. So maybe it’s not as simple as Fidelity had hoped, and the old rule of the thumb based on 25x your estimated net expenses will be more accurate and useful.
Here’s an idea. As your income grows, instead of steadily ramping up your expenses and increasing your standard of living, save more and more of your salary. You’ll augment the smaller annual savings from earlier in your career when you earned less with the larger annual savings from later when you earn more. You’ll smooth out your expenses over your lifetime and create a smoother, more sustainable standard of living instead of an expensive lifestyle based on your high ending salary that your cumulative savings can not support for 25-30 years of retirement. No amount of jiggling with hypothetical market rates of return can fix that shortfall.
How Big Is Your Thumb?
The trouble with rules of the thumb is everybody’s thumb is a different size. In earlier posts we have talked about using your estimated annual household retirement expenses (not your pre-retirement income), your household social capital (SS + pensions), and your household savings to determine your retirement readiness. Our guideline for a secure risk-free or low risk well-funded 30-year retirement is savings greater than 28.5x your estimated annual retirement expenses net of SS + pensions, regardless of the amount of your final annual income.
A lifetime financial plan is necessarily a household plan, not an individual plan, which often bridges several employer plans with different investment company administrators, savings in various accounts, and a number of options for taking Social Security and pension benefits that should be considered together, not individually.
In the next several posts, we’ll cover the risks we need to manage in a retirement plan, the different ways to build a risk-free or low-risk retirement income floor that is not dependent on volatile stock market returns, and the place an upside growth portfolio should occupy in your lifetime financial plan.