Guessing Game

Jonathan Clements

WE WON’T KNOW UNTIL we get there.

How much do we need for retirement and what will it take to amass that coveted sum? It sometimes seems like the entire financial advice business—brokerage firms, fund companies, financial planners, online calculators and more—is solely focused on this conundrum.

That’s mostly a good thing. It is indeed crucial to amass enough for a comfortable retirement. Still, let’s acknowledge an inconvenient truth: The resulting retirement projections imply a degree of precision that’ll likely look hopelessly naïve once the real world intervenes. Here are three key pitfalls:

1. Market mayhem. Through our initial decades in the workforce, it doesn’t much matter whether the financial markets are kind or cruel. Why not? At that early juncture, the biggest driver of our portfolio’s growth is the actual dollars we sock away. Moreover, if returns are indeed lousy, it’s often a plus: Our savings will buy stocks and bonds at cheaper prices, and those dollars should eventually enjoy higher returns.

But as we approach retirement, with fat portfolios but relatively few years left to save, it’s hard to be so sanguine about market performance. Whether we get wonderful or rotten returns will make a huge difference to our ultimate nest egg.

Let’s say we’re 10 years from retirement, with $300,000 socked away. If we hold a 60% stock-40% bond mix and we get returns that look like the past decade, our $300,000 might balloon to more than $630,000. That should be enough to generate over $25,000 in annual retirement income, which would then supplement whatever we get from Social Security and any pension. But if returns look like the decade before—the 10 years through September 2009—we’d retire with less than $410,000. That would give us just over $16,000 a year, assuming a 4% withdrawal rate.

What to do? I fall back on the advice I often dish out: We should save as much as possible early in our careers. If all goes well, we’ll enter that final decade in decent financial shape, so lousy investment returns during those last 10 years shouldn’t badly derail our planned retirement.

2. Lifestyle creep. As we advance through our working years, our cost of living climbs. There’s the obvious reason: inflation. Less obvious: Our collective standard of living rises not with inflation, but with per-capita GDP, which in the U.S. has increased 1.6 percentage points a year faster than inflation over the past 25 years. In the early 1990s, we didn’t have cell phones, internet access and next day delivery. Today, we expect such things.

Moreover, for many of us, our living expenses rise even faster than per-capita GDP. As we get periodic promotions and accompanying pay raises throughout our career, our lifestyle creeps upward. The upshot: The nest egg we need in our 60s to maintain our standard of living is likely far larger than the one we needed in our 20s. That means our earlier retirement projections will likely be badly off and, if we don’t revise them, we could end up with a nest egg that’s too small to sustain our lifestyle.

What’s the solution? Suppose we start our working career by saving 10% or 12% of our income toward retirement. As inflation climbs, we should increase the dollar amount we save each year—and, if we receive a pay raise that’s above the inflation rate, we might sock away half of that additional amount.

3. Savings interrupted. Retirement projections often assume we’re able to save steadily throughout our careers. But stuff happens: Bosses fire us. Spouses leave us. Illness derails our career. Children turn up and expect to be fed, clothed and educated.

To prepare, we could super-charge our savings early in our career—or we could try to compensate by toughing it out in the workforce for longer. It is, however, dangerous to bank on working late in life.

Why? According to the Employee Benefit Research Institute, workers say they expect to retire at age 65, on average, and yet the typical retirement age turns out to be age 62. That early exit might be prompted by illness, layoffs or simply a growing disenchantment with the work world. Whatever the reason, it means three fewer years to sock away money and earn investment returns, plus three more years of retirement to pay for.

At that point, with the chance to save now passed, the key is to spend less. If we find ourselves retired before we planned, we should move quickly to cut our living costs. Probably the biggest cost savings is to trade down to a less expensive home.

We might also look to squeeze more income out of the nest egg we have. How? We could pay for our initial retirement years out of savings, while delaying Social Security to get a larger monthly check. Similarly, we might turn a chunk of our savings into a stream of guaranteed lifetime income by purchasing an immediate fixed annuity.

My goal here isn’t to dissuade you from making retirement projections. If that inspires you to get your financial act together and it gives you a sense of financial control, go right ahead. But if you’re going to project, project often, because your required number will change constantly. What if you come up short? You’ll do what retirees have always done: You’ll find some way to muddle through.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Improving the Odds50 Shades of Risk and Show Me the Money. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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