Thursday, February 10, 2011

Retirement Scenarios for the 401(k) Generation

Let's explore some real-life retirement scenarios and see how much money we need to retire.

How much money do you need to retire?  The answer is, without being flippant, how much you end up with.  You see, that is what actually happens in real life to most of us.  We stagger along in life until one day we end up retired, either by choice or by circumstance, and whatever is left over, that is what we have to work with.

For the 401(k) generation, how much we save is how much we can retire on.  And to some extent, this is a huge experiment with an unknown outcome.  How much do you need to save for retirement?  No one seems to want to give out hard numbers - for good reason.  Let's explore some scenarios using real numbers and see what we can project:

1.  Retire on Social Security:  I have mentioned this before in the past that I know some folks who, through circumstance (spendthift behavior) ended up retiring on Social Security.  While this may look like a "worst case scenario" for most folks, actually, it can be even worse.  I have another friend who smokes a lot of pot, lives with his parents, and has worked odd jobs "under the table" most of his life.  He won't even qualify for Social Security!  Retirement on Welfare (SSI).  Ouch!

How much you get on Social Security depends on how much you kicked on.  The minimum benefit is not a lot and depends on the number of years you have worked.  The maximum benefit is $2366 per month, at the time of this writing, which assumes you made the maximum amount of money (the cutoff amount) since age 21.

So you see, right off the bat, it is hard to quantify even this simple scenario, as how much you get in Social Security benefits is a big "it depends".  And another factor in that scenario is that "it depends" on when you want to retire - age 62, 67, or 70?

OK, now we can see why the "financial gurus" don't want to give out specific numbers.  If you can't even quantify Social Security benefits without a "it depends" kind of answer, how can we even approach the rest of the equation?  We are talking about a 3rd order equation with 8 unknowns - impossible to solve with any certainty!

According to the Social Security Administration, I will qualify for about $1500 a month from age 62 onward.   As I noted in my "When should you collect Social Security?" posting if you crank the actuarial tables and a calculator, it ends up that collecting earlier can be better (or at least no worse) than "waiting" until age 67 or 70.  So let's assume a couple can collect $3000 a month from Social Security in retirement, which is not hard to do, if both worked for many years and made about $40,000 to $60,000 a year or so.

That works out to an annual income of $36,000, just on Social Security.  Is that enough to retire? 

Sorry.  Once again, we run into our old friend, "It depends" (and if you are looking forward to retirement, look forward to another friend called "Depends" - but that is another story).

Living expenses can be all over the map.  If you have a home that is paid for, and taxes and utilities that are reasonable (reasonably sized home in a low-tax area or an area that offers Seniors tax relief) then your monthly expenses for housing may be very low - a few hundred dollars or so.

On the other hand, if you retire with a mortgage, it just ain't gonna work - on Social Security.

There are cheaper places to live, of course.  A park model in a retirement community in Florida, for example, can be a very inexpensive way to live.  And many folks are opting to retire in places like Costa Rica or Panama, where the cost of living is cheaper.

But for most of us, retiring on Social Security alone would be a bleak retirement - one marked with privation and little in the way of options or leisure.

2.  Adding in the 4% Rule:  As I noted in an earlier posting, one rule-of-thumb investment advisers use is the 4% Rule (Some go as high as 5%).  Simply stated, this rule is that you should spend no more than 4% of your retirement savings per year, adjusting that amount for inflation.  If you stick to that rule, the money in your account should outlast you - at least in theory.

Assume we have $500,000 in retirement savings.  4% of this amount would be $20,000 a year - not a lot of money, but added to our $36,000 a year in Social Security produces a respectable $56,000 a year in retirement savings.  A couple could live on that, comfortably, and for many Americans, this is about the average income.

Now, granted, on that income, you could live comfortably, but not be going on extended cruises, buying brand new cars, or traveling all the time.

And there is the conundrum of retirement.  If you want to do fun things when you retire, you'll need more money.  But suppose you "do without" as a younger person, and then keel over dead at age 65?  You will feel a bit cheated, of course.

But in most cases, there is little risk of this.  Most Americans "live large" - or larger than they should - while younger, and end up in a retirement that is less than they expected.

So, for the sake of example, let's double that retirement account to $1,000,000 - the fabled million dollars, which would yield $40,000 a year in income and a total of $76,000 in retirement income, which should be fairly comfortable for most people.

A million dollars.  Is that realistic?  According to some sources, there are only about 3 million millionaires in America - about 1% of the population.   If this is correct, then very few of us have much saved for retirement - and most of us won't be making in the six figures when we retire.

But let's assume that is a "reasonable amount" of savings for retirement.  Cranking those numbers, how much do you need to save for retirement?

3.  Compound Interest Calculator:  Using a compound interest calculator we can work out a number of scenarios you might work in order to reach that one-million dollar mark.

But, once again, our friend "it depends" comes into play.  For example, what rate of return should we assume?  How many years do we factor in?

If we assume a 5.5% rate of return and a 45 year working life (age 20-65) then you'd have to put away $5000 a year to reach that one-million dollar mark.

For a 20-year-old just starting out, this is a hard number to achieve.  For a 50-year-old, a shameful one.  So once again, messy life gets in the way of making calculations.  We tend to save less when young, because we make less and have less disposable income (and spend more on toys and junk).  We have more money to save when older.  So the idea that we would put aside the same amount of money every year is a bit specious.

If you are older than 20, you can plug some money into the compound interest calculator and then "do the math" so to speak to see how much you will need to save for retirement, or see how much you will have when you retire, based on what you can realistically save between now and then.

Then, using the 4% rule (some financial advisers say 5% is a better target) plus your Social Security income projections, you can figure out how much monthly and annual income you will have in retirement.

4.  More "It Depends": Of course, this all assumes that the economy will remain relatively stable - that inflation won't wipe out your savings, that your rate of return on your investments will be 5% or more - it is based on a lot of assumptions in life.

So it is not hard to understand why the financial columnists waffle a lot when pushed to come up with a retirement number!

And then there is the aspect of optimizing your outcome.  If you live a life of privation in order to save for retirement, and then die early, obviously your outcome was not optimized.  If you knew in advance when you would die (how cheerful!) you could spend your money in a way that would optimize your enjoyment of it, instead of leaving it to ungrateful heirs.

And there, in a nutshell is the beauty of the "defined benefit pension" and the big problem with the "self-funded pension".  With a defined benefit pension, you don't have to worry your whole working life away about how much to spend versus how much to save, or whether you will outlive your money.

With the 401(k) plan, we spend every waking hour worrying about these things.  Do I have enough put aside?  Should I buy this baloney sandwich or put that money in my Roth IRA?  Will I outlive my money and end up eating cat food in a run-down trailer somewhere?

The 401(k) generation certainly got a raw deal, or so it would seem.  On the other hand, if you invested wisely, put aside some money, and live a normal lifespan, you may end up with more cash in your hand - and more overall wealth to leave behind to others.  It is a capitalist lifestyle, not a socialist one.  In the defined pension scenario, you might "make out" if you live long, but you end up as a passive consumer and dependent on the whims and wills of others.

5.  My Personal Goals:  OK, so how big is your retirement account?  Drop your drawers and get out the measuring stick!

If I save no money at all, between now and age 65, and get a modest 5% rate of return on my existing investments, then I should be in the fabled Millionaires club by then.  Of course, that's Millionaire with a capital M.  I'm already in the small-m club.   And I expect by the time I retire, the number of Millionaires in this country will be far above 1% of the population, as the 401(k) generation retires.

But of course, being a millionaire (or Millionaire) ain't what it used to be.  When I was a little kid, I thought that if you had a million dollars, you were set for life.  And many people today still think like little kids. 

But here's the rub:  If you are a millionaire and you spend that money, well then, you ain't a millionaire anymore.  Lottery winners always fail to figure this out.  A million dollars, spent at even the 4% rule, will run out of money in about 25-30 years.  And the resulting income isn't very much to live on.

So once you save money, well, you can't just say "Gee, I'm rich, let's go out and spend it".  It doesn't work that way.

And as these calculation scenarios illustrate, even saving the fabled "million bucks" doesn't work out to a lot of income in retirement - particularly when you are trying to calculate events more than a decade from now.

So my goal is hopefully to be a multi-millionaire between now and retirement.  But I also want to enjoy life between now and then - travel and goof off as much as possible.  They are, of course, conflicting goals.

6.  Suppose You Have No Savings?:  Many folks are age 50 and older and just starting to think about retirement.  More than one 55-year-old has said to me "I'm thinking of starting a retirement account one of these days" - as if you can somehow save up enough money in the 5-10 years before retirement.

And more than one 55-year-old has told me of cashing in 401(k) or pension plan monies to pay off credit card debts or to pay for a lifestyle today.  Ouch.

If these scenarios describe your situation, I am not sure what to advise, other than to make a plan NOW and work toward the best retirement possible given your circumstances.

Living on Social Security (our first scenario) may be harsh, but it will be even harsher if you retire with a mortgage and other debts.  Have a plan in place to pay down and pay off these debts before retirement, so you can at least live on your Social Security.

Above and beyond that, anything you can save will mean that much better for you in retirement.  Maybe $20,000 doesn't sound like a lot, but it beats nothing.

The point is, it is never too late to change course and make things better for yourself.  If you are age 55 and have no retirement savings, then yes, your retirement years will not be as much fun as they could be.  But that is no reason to jump off a bridge just yet.  You can still afford to retire and live comfortably, although not luxuriously, if you start planning now.

7.  So what's the Answer?  The "rules of thumb" that most retirement planners use - have a year's salary in savings by age 30, spend no more than 4% of your savings annually in retirement, put aside 10% of your income into savings, etc. are there (and are purposely vague) as there is no hard and fast rule or way to calculate, with certainty, how much money you will need, without a lot of waffling and "it depends".

Having some money in the bank does provide one benefit beyond that of having shiny things in the driveway - security and peace of mind.  While most people trying to sell you "peace of mind" are selling snake oil, having money in the bank is real peace of mind, in the form of security.

And the funny thing about saving is this:  When you start saving money and realize how hard it is to put aside a dollar, you get more aggressive about cutting costs in spending.  When you borrow, prices don't seem as important, as they don't affect the fabled "monthly payment" so much.

So save as much as you can, as it will create a snowball effect.  Have a financial goal in mind for retirement - the $1 million mark is not a bad goal, for anyone making $50,000 a year or more (and it is feasible).  If you only hit half that, you will still be doing pretty well.

Retirement for the 401(k) generation is just starting.  The next 20-30 years will be an interesting time in our country.  Self-funded retirement plans are an interesting experiment, and it will be interesting to see how this experiment pans out over time.