Accumulating Savings for Retirement of 8x or 10x Pay is Better than 4x or 6x

Recently two long-time associates of mine at Towers Watson, Gaobo Pang and Dr. Syl Schieber released American Workers' Retirement Income Security Prospects: A Critique of Recent Assessments arguing that "some recent assessments of what workers should save and when they should save it dramatically understate the adequacy of retirement savings for many households."  In this article and a summary article published by Towers Watson, they suggest that accumulated savings of four times or six times annual pre-retirement gross earnings will be sufficient to replace pre-retirement standards of living for the average worker.  They use their "life cycle structure of consumption" approach to develop lower replacement targets than developed by others and argue, "why should...workers reduce their working lifetime consumption by a total of two or three or more years of earnings in order to achieve a higher standard of living in retirement."  They express concern that, "if workers are led to believe that they are so far off a reasonable savings path that an adequate retirement income is beyond reach, it raises a question of whether some workers will not become so discouraged that they will give up on saving for the future."
 
My friends at Towers Watson make good arguments why a one-size savings rule of thumb will not fit all workers.  For example, in addition to different replacement rates provided by Social Security benefits, some workers will have other supplemental sources of retirement income, other retirement income needs, and others will retire earlier or later than age 65.  And while I share the authors' concern that there may be many workers who are discouraged about saving for retirement by big numbers, I don't believe the answer lies in giving workers a smaller target that will likely fall short of meeting their needs, and I worry that workers may reduce their current savings efforts in light of this research. 

As I indicated in my August 11, 2013, my friend and actuary, Steve Vernon, had a great, concise two-step process for retirement planning:

Step 1:  Plan to support the life you want using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.

Step 2:  Be prepared in the event that your forecasts are wrong

In other words (and the words I use throughout this website), step 2 requires you to assess and manage your risks in retirement.  And I believe that if you have no other sources of retirement income other than Social Security and you are a medium or above earner, you will be in a better position to manage these risks if you accumulate at least 8X or 10X your annual earnings at retirement rather than 4X or 6X.

The authors developed their target savings multiples by assuming hypothetical workers born in 1949 retire this year, commence their Social Security benefit this year and somehow purchase a very favorably priced indexed joint and survivor annuity using assumptions for mortality and interest used by Social Security actuaries.  Those excited about the authors' resulting lower savings targets should note that under current law, future age 65 Social Security replacement rates will be somewhat lower than the rates used by the authors for individuals born after 1954 (reaching about 7% lower for anyone born after 1959).  In addition, because of Social Security's financial difficulties, future benefit reductions of something like 25% may be required sometime in the 2030s when the OASDI trust fund is projected to be exhausted if tax rates are not increased. 

The two tables shown below illustrate total retirement income (Social Security plus withdrawals from savings) for the medium earner and high earners described in the authors' paper using the authors' data, except instead of purchasing a hypothetical annuity at retirement, the workers are assumed to follow the withdrawal strategy and recommended assumptions described in this website.  I leave it up to the reader to determine which level of savings under these circumstances best produces the reader's desired level of retirement income.  Remember that the income shown is before taxes.  

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Why is it prudent for workers to set higher target multiples of savings than 4X to 6X earnings?

Here are a few reasons:

There are multiple risks in the many years of expected retirement that can work against the retiree:  poorer than expected investment income, longer than expected longevity, higher than expected inflation.  These risks can be managed to some degree with lifetime insurance products, but these products bring their own set of risks with them.   As I have said many times in this blog, it may make sense to manage these risks by combining life insurance products with a sound withdrawal strategy. 

As noted above, Social Security benefits commencing at age 65 (a large portion of the projected total income for the hypothetical medium and high earner shown in the tables above) are scheduled to decrease in the future from current replacement levels, and may need to be reduced even further to keep the program financially solvent.  Further, many people do not wait until age 65 to commence Social Security benefits.  Some workers find that they are no longer employed at that age.  Social Security statistics show that for whatever reason about half of all Social Security retirement benefits commence at age 62.  So actual Social Security benefits may not produce as high a replacement rate as shown in these tables. 

Some individuals may want to leave amounts to heirs upon their death.

Some individuals may want to be able to do more and live better in retirement than they did prior to retirement.

Bottom line:  Targeting savings of just 4X or even 6X pay at retirement may be cutting it too thinly for some individuals.  Better that you make your own decision by crunching your own numbers based on your situation and desires rather than relying on someone else's rule of thumb estimate.    

Is the 4 Percent Rule Still Relevant for Retirees? Uh, Hells No.

Thanks to David Ning for posing this question in his recent post.
 
Readers of this website will note that over the past four years about half of the posts have been raves against the 4 Percent Rule, so you will undoubtedly not be surprised to know that I agree with Mr. Ning's conclusion on this one.  However, it is one thing to criticize the 4% Rule and another thing to offer readers a solution (other than Mr. Ning's, "perhaps the safe number is now 3.5 or 2.8 percent.")

The solution is to use a better strategic withdrawal approach.  Fortunately, the actuarial approach recommended in this website is a better approach than the 4% Rule.  If you have Excel on your computer, it is very easy to use.  See our post of December 27 of last year for an example.