Monday, September 12, 2011

Getting on Track for a Sustainable Retirement: A Reality Check on Savings and Work

A recent paper by Wade Pfau really overturns some standard ideas about retirement planning. The usual story includes picking a "number", planning how much you need to save to get to the number and starting early with saving in order to benefit from compounding interest. This table from the paper:

shows what percentage of final retirement assets could be explained by accumulated wealth a given number of years before retirement for a bond-stock portfolio simulated over the last century or so for the US. Even with an all bond portfolio only 43% of final wealth could be explained by accumulated assets 10 years from retirement. For stock oriented portfolios very little of the variation could be explained. It's all down to the luck of the market returns in the final 10 years. So tracking net worth doesn't really help much in telling you how much you'll have to retire on after all... Early compounding doesn't make much difference because there isn't much wealth to benefit from compounding.

So what does Pfau recommend? Calculating a minimum safe savings rate based on age, accumulated assets, and allocation. For someone of 55 years old who has saved 4 times their salary and wants to replace 50% of their salary and retire in 10 years and has 60% in stocks, the minimum safe savings rate is 52% of income! For a 50% chance of success of achieving a sustainable retirement only an 18.2% savings rate is needed. Having more wealth earlier does help reduce these rates. Not because of compounding but just in terms of piling up more savings. There are more analyses in the paper of the effect of retiring later etc.

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