(Bloomberg) — U.S. workers are worried about retirement, and who can blame them? We’re living longer. Social security looks increasingly overburdened. Employers have ditched pensions in favor of laughably inadequate 401(k)s and other defined contribution plans.
According to Willis Towers Watson, a human resource consulting firm, 71 percent of full-time employees believe that Social Security will be “much less generous” when they retire than it is today — and 76 percent believe that they will be “much worse off” in retirement than their parents.
In the absence of any meaningful effort by the public or private sector to address those fears, many workers are doing the only thing they can do: planning to work longer. About 47 percent of full-time employees who are members of a retirement plan told Willis Towers Watson that they would work longer if they thought that their retirement income would fall short (the other, less popular, options were to save more, live more frugally, or hope for the best). And 28 percent of full-time employees expect to work past the age of 70 (including 5 percent who expect to never retire).
A career that stretches into a fifth decade — from one’s 20s to 70s — may not be a welcome development to all or even most workers, but it does have at least one benefit: It profoundly improves workers’ ability to save for retirement and, by extension, gives us greater tools for beating back a budding retirement crisis.
This magic elixir is actually just simple compounding. Think about this: With a 50-year investment period, the average American’s retirement can be funded with just $16,500. Really.
The median household income in the U.S. was roughly $54,000 in 2014. A common rule of thumb in financial planning is that retirees should aim to replace 80 percent of their pre-retirement income. (Some observers argue that this “replacement ratio” can be even lower because retirees no longer need to save for retirement or pay employment taxes, among other cost savings, but let’s be conservative.) So this means that the average U.S. household will need roughly $43,000 in retirement income.
Some of that income will come from Social Security. In 2015, the average annual Social Security benefit was just over $16,000. Let’s grant that future benefits will be lower and cut that benefit by 25 percent to $12,000. That means workers will have to come up with the other $31,000.
Here’s where it gets interesting. Another well-known rule of thumb in financial planning is that retirees should withdraw no more than 3 percent to 5 percent of their investments each year. Let’s split the baby and assume that the average worker will withdraw 4 percent. In order to generate $31,000 every year, she will need a nest egg of $780,000.
That sounds like a huge sum, but this is where the magic of compounding comes in to play. A portfolio allocated 50 percent to the S&P 500 and 50 percent to five-year U.S. treasury notes has returned 8 percent annually since 1926 (including dividends). If you were to invest $16,500 in a portfolio that grows at 8 percent annually, 50 years later you would have $780,000. (I concede that neither U.S. stocks nor bonds are priced to provide that kind of return today, but I think the long term average is a useful gauge for what’s likely to happen over multi-decade periods.)
$16,500+50 Years+8 percent =
It’s not readily apparent in the numbers, but that fifth decade is critical. That same $16,500 would grow to just $360,000 in 40 years — less than half of what’s necessary to fund the average worker’s retirement. The fifth decade contributes the other $420,000. So the upside of a five-decade career is that, with some forethought, the average worker’s retirement can be funded with a very modest sum.Obviously, $16,500 doesn’t just drop out of the sky for many people. (It’s like the old Steve Martin joke: “How can I be a millionaire … and never pay taxes? First … get a million dollars.”) I think there are creative ways for the public and private sectors to help young investors amass $16,500, though, and in a companion column I’ll explore some possible approaches.
But for starters, we should permit workers to set aside as much of their incomes as they want tax free until they turn, say, 25, subject to the current restrictions on withdrawing money from retirement accounts. Workers should be permitted to invest this money in any IRA, not just an employer-sponsored retirement plan.
Separately, employers should offer aggressively higher 401(k) matches for young employees in order to incent them to save early. Even better, employers who can afford it should set aside, say, $20,000 in a retirement account for every employee at the beginning of employment, subject to some reasonable vesting requirement. What could be better for both the employer’s public image and the employee’s retirement fortunes?
There’s no such thing as a free lunch, of course. The downside of longer careers is that there’s also more opportunity for workers to make mistakes — to put off saving for retirement even longer or to take wild gambles believing that they have more time to recover losses.
Given the stakes, we shouldn’t just shrug our shoulders in the face of those risks. We should leverage longer careers to provide better retirement outcomes for all workers.
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