What is a Viable Mix for Retirement Savings Success?

Are you on track for building a financially sustainable retirement? How can you know if you are making progress whether you are 35 or 55?

Saving and investing enough depends on several factors that inter-twine and affect one another:
- what age you stop working and retire,
- how many years you save,
- your savings rate,
- your desired retirement spending,
- how long you will live,
- the returns from the portfolio where your savings are invested.
In addition, there is the make-up of the portfolio between stocks, bonds and other asset classes to decide.

It is easy to see that deciding on a viable mix can seem dauntingly complex. Obviously, the longer you work and save, delaying retirement, the lower the required savings rate needs to be. The more stocks in the portfolio as opposed to bonds, the higher the return should be, but there is more chance of stocks doing one of their familiar nose-dives at the wrong time, just at the start of retirement. The question everyone faces: what are the numbers to use?

The Past as a Guide
One way to get a good idea, if not a definitive answer, since we can never be sure the future will be exactly the same, is to look at what happened and what worked in the past. Using a long enough period that includes recessions, inflationary periods, depressions, booms, wars, financial crises, bubbles and crashes, we can gain some confidence that the numbers might be worth considering.

Enter researcher professor Wade Pfau of the National Graduate Institute for Policy Studies in Tokyo, Japan, who has done some interesting number-crunching in his paper Getting on Track for a Sustainable Retirement: A Reality Check on Saving and Work. He has figured out what various combinations of retirement age, income replacement level and asset allocation would have ensured that a person would never have run out of money up to age 100 (few of us get to live as long as Jack Rabbit Johannsen) assuming that the person had already saved a certain amount to date. In other words, he has looked at the worst case scenario for anyone retiring anytime during most of the 20th century (though he cannot go beyond anyone who would be less than 100 in 2010 e.g. a 55 year old retiree of 1965, who would have 45 years of retirement by 2010, or a 65 year old retiree of 1975, who would have 35 years).

The Example of a 55 Year Old
Pfau uses as his base case the example of a 55 year old making decisions about what to do. This is what Pfau determined.

• To maintain a spending rate of 50% of final salary, a person could have retired at 67 if he/she had already accumulated savings of six times his/her annual salary and was prepared to save 15% of their annual salary continually till retirement using a mix of 60% stock (S&P Composite Index) and 40% fixed income (six-month commercial paper) - see the blue-circled cell in the top panel of the table below copied from the paper. For instance, a person earning $60,000 per year would need to have $360,000 in retirement savings already and to set aside $9,000 per year till age 67.
• If the person lowered the stock allocation to 40%, retirement age would rise to 70 - per the middle panel blue-circled cell
  
• If the person wanted a higher 60% of final salary replacement spending level, retirement age would rise to 69 - per the lower panel blue-circled cell
• If the person had only saved up four times their annual salary so far and could only manage to save 10% of earnings per year, retirement age would rise to 72 - per the upper panel red-circled cell.

Ages 35, 40, 45, 50 or 60
Prof. Pfau has used the same assumptions and methods to calculate the path forward for individuals 35, 45, 50 and 60 in his blog post Getting on Track for Retirement. The table for 40-year olds is here in another post.

Taking one example from these tables, we see that a 35 year old with zero retirement savings today could still retire at 66 (blue-circled cell in the table below) at the 50% spending rate by saving 15% per year.

Stock Allocation Sweet Spot 40 to 60%
One fascinating fact coming out of the middle panel of all the tables, whatever the age at which the look forward starts, is that an optimal allocation percentage to stocks looks to lie between 40% and 60%. A higher allocation to stocks lowers possible retirement age little if at all. Below 40%, the safety of fixed income comes with a significantly increasing higher retirement age, due no doubt to the much lower returns historically achieved by fixed income.

Lower Income Replacement Gives Earlier Retirement
A 10% cut in income replacement rate from 50% to 40% has as much effect in lowering viable retirement age - three years, from 67 to 64 - as having saved eight times your salary by age 55 instead of only six times (see the green circled cells in the first table above). In the example of the $60,000 earner, is it easier or more worthwhile to save $480,000 instead of $360,000 by age 55, or cut annual retirement spending from $30,000 to $24,000.

Caveats and Cautions
We believe that though very useful, the tables should be used to ballpark and to judge rough trade-offs, not to set precise expectations.

• Data is for the USA and though similar, Canadian investment returns have not been identical and will not be in future either. Whether this means higher or lower, we cannot be sure since Prof. Pfau has not run any numbers for Canada.
• Investment management fees have not been deducted as the study uses index data. That would lower returns and raise potential retirement age and required savings rates to obtain the same income replacement rate.
• A constant spending rate throughout retirement probably over-estimates what usually happens as people slow down as age advances. People also can cut back if returns are poor. Similarly, setting 100 as the age to which income is required overdoes it since life expectancy, while it continues to creep up constantly, is still only just over 80. Applying those factors would all enable a lower retirement age or lower savings rate.

The test that the portfolio should never have run out of money is very stringent. The high required savings rates are necessary in a minority of all the years considered, as Pfau's figure 4 shows. Taking a chance that the retirement years will be blessed with reasonable investment returns may suffice. Which part of the past will the future be like? No one knows. Pfau lays out an ultra-cautious approach. It may not even suffice if the future brings something worse than any period yet recorded. We sincerely hope, and expect, not.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.