Sunday, March 26, 2017

Hey Millennials, How Much of Your Pay Should You Be Saving?

So, you are a Millennial who is employed but hasn’t started to save yet. The “experts” tell you that you need to start saving like yesterday and you need to save as much as possible. This post will walk you through how to use our Actuarial Budget Calculator for pre-retirees so that you (or your financial advisor) can develop a spending/savings budget that will help you accomplish your financial goals. 

In their recent article in the Journal of Financial Planning, “Planning for a More Expensive Retirement,” PH.D.’s Blanchett, Finke and Pfau develop a life cycle model to determine, among other things, savings rates required in a low investment return economic environment to replace hypothetical individual’s pre-retirement standard of living, assuming retirement occurs at various ages.  These gentlemen conclude,

  • “Savings rates would need to rise sharply for households hoping to maintain the same standard of living in retirement if real asset returns are low” 
  • “Advisers may need to modify expected returns in planning software to provide clients with more realistic projections on meeting long-term spending goals.”, and 
  • Advisers using historical asset return data or outdated mortality assumptions may be providing clients with an unrealistically optimistic estimate of either the age at which they can comfortably retire or the amount of savings needed to maintain their current lifestyle.”
In Table 3, the authors’ model shows that if returns remain low, the necessary current savings rate for a single 35-year old making $50,000 per annum with no current savings who wants to retire at age 65 with the same standard of living is 18.1%. This savings rate jumped to 23.66% for an individual currently making $200,000. If retirement is deferred to age 70, however, the savings rates are reduced to “just” 12.74% for the $50,000 individual and 19.76% for the $200,000 individual.

The authors’ model is reasonably complicated and not particularly transparent.  With a little bit of work, however, we were able to use our Actuarial Budget Calculator for Pre-Retirees and our recommended assumptions to come reasonably close to their low investment environment savings rates for hypothetical 35-year old’s currently earning $50,000 and $200,000, respectively. We describe the assumptions and method we used below, so that Millennials and other pre-retirees (or their financial advisors) can duplicate our results and use our workbook to develop their own spending/saving budget based on their own situation and assumptions.

Assumptions and method:
  • No initial accumulated savings (B7) (including no initial 401(k) balance) 
  • Desired number of years until retirement (B 11): 30 years for retirement at age 65 and 35 years for retirement at age 70 
  • No income from other sources except Social Security and company sponsored 401(k) plan that matches employee contributions $.50 for each dollar up to 6% of the employee’s pay.  
  • 401(k) plan matching contributions (B 17): Each hypothetical worker is assumed to contribute at least 6% of pay each year, so the initial match is $1,500 for the $50,000 worker and $6,000 for the $200,000 worker.  Subsequent years matches are assumed to increase at the same rate (B 19) as used for assumed pay increases.  
  • Investment return/discount rate (B 21): 4% per annum (2% real return) 
  • Inflation (B 23): 2% per annum 
  • Lifetime planning period (B 25): 60 years (death at age 95) 
  • Pay increases (B 13): For $50,000 worker: 3% per annum; For $200,000 worker: 3.6% per annum 
  • Present value of unexpected expenses (E 39): For $50,000 worker:  $25,000; For $200,000 worker: $100,000 
  • Present value of Long-term care expenses (E 37): For $50,000 worker: $75,000 or $0; For $200,000 worker: $75,000 
  • Desired amount remaining at end of lifetime planning period (E 35): $0 for both workers 
  • Annual increases in spending budgets after assumed retirement (E 33):  For $50,000 worker: 2% per annum (maintain real dollar purchasing power); For $200,000 worker: 1% per annum (decreasing real dollar purchasing power). 
  • Reduction in expenses on retirement: For $50,000 worker: 15% of gross pay just prior to retirement; For $200,000 worker:  10% of gross pay just prior to retirement.  See below for more discussion of the implications of these assumptions.  
  • Except as noted above, no other non-recurring pre-retirement or post-retirement expenses (such as education expenses, home improvements, etc.) 
  • Social Security benefit at assumed retirement age (E 15): We used the Social Security Online Quick Calculator for this purpose.  We selected amounts to be shown in future dollars and adjusted future earnings where necessary to approximately match our pay increase assumption. For the $50,000 individual, this meant that we used a -.9% adjustment to the default earnings used by the calculator to produce about a 3% per year increase in future earnings. For the $200,000 worker, we entered 2017 earnings of $127,200 with no adjustment to the default increase assumption. The resulting estimated benefits for the $50,000 worker were $52,344 (annual) assuming retirement (and commencement) at age 65 and $86,448 assuming retirement and commencement at age 70. Benefits for the $200,000 worker were $92,232 at age 65 and $153,804 at age 70.  The runout tab of our workbook shows pay in future dollars for the year prior to desired retirement, so that you can approximately match that amount with the pay amount shown for the year prior to assumed retirement in the Quick Calculator. 
  • Social Security start year (E 17): 30 years for retirement at age 65 and 35 years for retirement at age 70 
  • Process used to solve for savings rate needed to replace pre-retirement standard of living (B 15): This is where it gets just a little more complicated.  We had to use a trial and error process to solve for the necessary savings rate that would replace the hypothetical workers’ pre-retirement standard of living because increasing the savings rate decreases the target pre-retirement standard of living. The equation we used for this purpose for the $50,000 individual was:
[(1 – Savings Rate (SR)) - .15] / (1 – SR) = ratio of first year spending budget to final working year spending budget, in real dollars from our workbook (E 60). The .15 factor was our estimate of the proportion of the $50,000 worker’s pre-retirement gross pay represented by FICA taxes, work-related expenses and other factors that we assumed would not need to be replaced after retirement.  We estimated this percentage to be about 10% for the $200,000 worker. Note that this process is more complicated, but more consistent with the concept of replacing one’s pre-retirement standard of living than simply solving for the savings rate that will produce say a 80% ratio in E 60.


The table below shows our workbook results for the two hypothetical 35-year olds based on the assumptions and method above vs. the authors’ results.

(click to enlarge)

While our results are comparable, we tend to show a bigger decline in the required savings rate associated with working until age 70, rather than retiring at age 65 than the authors. This may be due to our constantly increasing pay assumptions. 

So how much of your pay should you be saving?

Our Actuarial Budget Calculator gives you a tool to develop a spending/savings budget based on your situation, your assumptions and your financial goals. You may feel that savings rates developed using our workbook and our recommended assumptions are too high because you will earn a higher real rate of return than 2%, you will never retire, you will work part-time after retirement or you will have other sources of income. On the other hand, it is certainly possible that:
  • your estimated Social Security benefit under current law may be reduced in the future (see our post of December 15, 2016),   
  • your employment may cease prior to your desired retirement date, 
  • you may desire a higher standard of living after retirement than before, or 
  • you may have other expenses such as college education costs or home improvements for which you also need to save.  
You will also need to decide whether saving for purchase of a home requires additional saving or whether the value of your home can ultimately be used to meet some of your expenses in retirement. 

Even though our workbook simplifies the calculation process to some degree, this planning and budgeting stuff may seem too complicated to you, too much work or just too painful to consider at this time. We understand that you may not be currently focused on saving for your retirement. It is not too early, however, to develop a financial plan for the future, and we encourage you to consult with a financial advisor or use our ABC for pre-retirees for this purpose. We know that this is a tough task, but we assure you that it can be done.  We just read about a 31-year old who saved over one million dollars in just 5 years.  His motivation for starting to save? He used a retirement calculator that told him he needed $1.25 million to retire.