Is it possible to save too much for retirement? Isn’t that a bit like eating too many green vegetables? Recently, I read an article by journalist Constance Brinkley-Badgett, Are You Actually Putting Too Much Money Away for Retirement?, challenging the common financial planning guideline of using a generic “replacement rate” for retirement savings. Brinkley-Badgett quoted David Blanchett, CFA, CFP®, of Morningstar regarding his research into retirement income replacement rates. Do people really not need to save as much for retirement as they think they do?
The simplicity of this message worries me – a lot. According to a study by the Federal Reserve, 31% of American households don’t have any retirement savings at all…not one dime. Even if it’s true that some higher net worth households are “over-saving,” the far more urgent national problem is that most Americans are not saving enough.
There are two common, interrelated retirement planning guidelines. The first is that you should target replacing 70-80% of your pre-retirement income. Why 70-80% and not 100%? Primarily because you no longer have to save for retirement or contribute to Social Security.
However, Blanchett asserts that 80% may be inaccurate, and that based on his research the replacement rate range is a wide 54-87%. “The true cost of retirement is highly personalized based on each household’s unique facts and circumstances,” he wrote in the report summary, “and is likely to be lower than amounts determined using more traditional models.” It’s a thought-provoking piece of research, and if you are interested in financial planning, it’s worth a read.
Another general guideline is known as the 4% rule for retirement account withdrawals. Based on a 1994 article by William Bengen, CFP® in the Journal of Financial Planning, the idea is if you withdraw no more than 4% from your retirement accounts the first year of retirement, then adjust your withdrawals in subsequent years for inflation, a portfolio of 50% stocks and 50% intermediate Treasury notes should last at least thirty years. The two work in conjunction: save as much as you need to generate an annual 4% inflation-adjusted withdrawal from principal over thirty years to cover 70-80% of your pre-retirement income.
While it is true that the 80% and 4% rules are “one size fits all” generalizations that can be improved by personalizing them based upon your health, your expected monthly expenses, your total savings and your expectations for activities in retirement as Blanchett correctly notes, not everyone can afford to have a personalized retirement plan made for them. What does this mean for someone who’s saving for retirement in their 401(k) plan and does not have access to the ongoing services of a financial planner? It is tempting to listen to the “save less” recommendation. After all, if you save less for retirement, you’ll have more money to enjoy life now. However, when we consider the basis for the 80% and 4% rules, we can see how even if your personalized replacement rate was 50 to 60%, you might still want to save for the 80% replacement rate (or higher).
A 95% success rate still means running out of money 5% of the time.
These rules were developed based upon studying how people could spend money in retirement in such a way that they can feel a level of confidence that they will not “outlive their money.” If one followed the 4% withdrawal rule, then you would have about a 95% chance of being able to live on your savings for 30 years. 95% confident sounds like a lot, but is it enough?
To see what this means, consider what would happen if you lived the same retirement over and over again thousands of times. In some of those lives, you’d get lucky and retire in a bull market, where stocks rise significantly, so your portfolio would always be enough. In others, you’d retire and the markets would fall 30% in the first year. The bottom line: during 5 out of every hundred lives you would run out of money before your thirty year retirement is up.
Past performance does not indicate future results
The model in Bengen’s original paper used long term historical rates of returns and inflation. However, the future may be different. While that could work out in your favor, with higher rates of return during retirement and lower than expected inflation leading to your savings lasting longer than predicted, the opposite could also be true. Rates of return could be much lower, and/or inflation could be higher, which means your money could run out sooner. You could also have the bad luck of retiring at the beginning of a bear market, with a few years of successive negative returns leaving you with a smaller portfolio to generate retirement income.
You could live much longer
According to the Social Security Administration, “a man reaching age 65 today can expect to live, on average, until age 84.3. A woman turning age 65 today can expect to live, on average, until age 86.6. And those are just averages. About one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.”
Even if your needed retirement replacement ratio were lower, perhaps because you paid off your mortgage or otherwise had significantly lower expenses, there is still a chance that you’ll outlive your savings. What if your money has to last you 40 or 50 years? One way to address that is to save more before retirement, but not spend more afterwards, so you have something left in your nineties. Aim for a 99% confidence level that you won’t outlive your money over a long retirement period.
When you consider that poverty is the price for outliving your money, you can see why financial planners generally want you to oversave for retirement. I don’t know about you, but I plan to live longer than 30 years. Since I can’t change what happens in the economy, I’m planning to save more – not less — than the 80% and 4% rules tell me.