The financial services industry finally seems to be getting its collective arms around the inherent differences between investors focused upon pre-retirement accumulation, for which the primary goal is return on investment, and those focused upon post-retirement distribution, for which the primary goal is the reliability of income.
But this distinction is in no way a disconnection. Accumulation cannot succeed without a clearly defined goal. One approach is “the number,” which the financial services conglomerate ING uses prominently in its ubiquitous advertising. It is based upon the work of Lee Eisenberg, and is designed to help investors figure out how much money they will need to retire comfortably based upon lifestyle choices and financial wherewithal. However, this approach may suggest more precision in the process than is really possible given the vagaries of time, investment returns, interest rates and life circumstances. It is particularly troublesome because so many people have difficulty figuring out how much income they will need in retirement. The academic literature suggests somewhere around 70-80 percent of final income over time, but that percentage tends to be higher early in retirement and lower later as one’s level of activity declines; but inflation and healthcare (including long-term care) are major wildcards in the calculation.
A better approach is offered by the National Savings Rate Guidelines for Individuals, created by Roger Ibbotson and others, which is designed to help investors at various ages, income levels and initial accumulated wealth figure out how much they need to save as a percentage of current income at various ages in order to retire comfortably. For example, this approach estimates the necessary savings rate for a 35-year old with a $50,000 annual income and $50,000 in savings to be 15.5 percent.
The data is relentless in showing the need to start saving early. The recommended savings rate for those starting to save at age 25 typically more than doubles if they wait until age 45 to start saving, and triples if they wait until age 55. Thus a person who is 35 years old and has income of $40,000 per year needs to save at least 12.2 percent. A person at 55 with income of $100,000, who is just starting to save, needs to put away a whopping 40.2 percent of salary.
Moreover, even aggressive savers have serious life needs that often get in the way of retirement planning. The desire to own a home takes a tremendous amount of capital in much of the country, even after major drops in housing prices on account of the bursting of the housing bubble. Parents who wish to provide college educations for their children are faced with public university costs that can total more than $25,000 per year and annual private university costs well in excess of $50,000. These prices may continue to go up dramatically in that state budgets — a primary source of public university funding — are in serious distress and on account of tuition inflation across the board that has grown at a rate far in excess of the CPI for decades.
During the housing boom in the middle of the last decade, some advocated using home equity as a means of funding retirement. But as more recent events and Professor Robert Shiller of Yale have demonstrated, it is a mistake to assume that home equity can offer the needed retirement nest egg. On a historical basis, homes have simply not provided investment return much above inflation.