No Substitute For Saving

Felix Salmon makes a point that we should all be paying more heed to: all the ordinary folks out there counting on 8-10% annual returns on their investment portfolios to salvage their retirements are headed for trouble.

Saving is lumpy; very few of us diligently start socking away $6,000 a year at age 25. (Well, maybe those of us who go on to become investment bankers do. But no one's worried about them.) In any case, of course if you keep savings constant, then the rate of return makes all the difference. That's a tautology.

But much more common is the person who struggles through their 20s, brings up kids in their 30s and then wakes up in a cold sweat one morning in their mid-40s, worrying about what they're going to live on when they retire. By that point they've had enough pay raises that they're going to need an enormous sum in order to maintain the style to which they've become accustomed. But at the same time they're spending everything they're earning already. So they put away what they can and count on 8% or 10% annualized returns -- or even more, if they're investing in dot-com stocks or Miami condos -- to get them where they want to be.

This, needless to say, is a strategy which is likely to end in tears. And it's not just individuals thinking this way, either -- municipalities do, too, and they really ought to know better.

My point is that the range of remotely sensible investment strategies for a working person is actually pretty narrow. You can't just wave a magic asset-allocation wand and change your annualized return over a period of 35 years by 300 basis points. Frankly, you'd be doing well if you could improve it by 30 basis points. The market will return whatever the market will return and you will do a little bit worse than that, most likely.

So the way to have a comfortable retirement is not to think that by making a clever choice when it comes to stock-picking or investment strategy that you can somehow make up for the money you're spending rather than saving. Instead, it's to diligently save as much as you can, from as early an age as possible and simply invest it in a non-idiotic manner. The more you save, especially in your 20s and 30s, the more you'll end up with in retirement.

Wall Street would love us to believe that the magic of compound interest gives us a free lunch; that a small amount of savings, if compounded at a high enough rate, can set us up for life. That might be true mathematically, but saving doesn't work that way in the real world. Interest rates are low, now, and wages are growing sluggishly.

The three big drivers of big retirement accounts -- sharply rising salaries, sharply rising house prices and a sharply rising stock market -- are all looking very uncertain these days. So let's not perpetuate this pipe dream that if only we can get an 8% return on our funds, everything will be fine. Because chances are we won't.

At this point, I think that most people who are likely to be reading this blog should be targeting a savings rate in the range of 20-25% of income, more if they can manage it.  Since this is approximately five times what the average American household is saving, this notion is likely to be met with fierce resistance by readers who can name an endless list of claims on their income: mortgage, utilities, car, kids' activities, clothes, visits home to see the family . . . 

But as Felix points out, you have to assume that you're not going to see 8-10% return on any of your assets: not your house, not your stock market portfolio, not your wages.  Say you're a 40 year old couple with 100,000 a year in after-tax income, and you save 5% of that, the way ordinary Americans do.  (Assume further that it all goes in retirement).  $5,000 a year at 5% until the age of 68 will leave you with $293,000 in retirement funds, which works out to about $1,000 a month in combined investment returns and withdrawals if you assume that you will live to 88.  On top of your Social Security benefits, your household will probably net about $4,000 to $6,000 a month.  But you're used to living on almost twice that.

Moreover, these assumptions are pretty optimistic.  They assume that you get a 5% real return, which is pretty high, considering that the stock market is still trading at 24 times historical earnings per-share, which is above its historical average range of 10-20 times.  It assumes that you continue to get that into retirement, which you shouldn't, since you need to be in less volatile assets which deliver lower average earnings. It assumes that your taxes don't go up, lowering your average income (Hint: this assumption is definitely not realistic). And it assumes that there's no gap in employment until you're ready to retire.

To be comfortable in retirement, you need to be saving a lot more, especially if you're planning to, I don't know, have an emergency, do anything large such as renovate the house, or put some kids through college.  This is definitely possible--look at the income your parents lived on.  How did they do it?  Not because those were halcyon days when incomes were better and working men lived like kings.  No, if you really think about it, you'll realize that they consumed less stuff than you, and you, especially, consumed less stuff than your kids.

Of course, this was easier to do, because other people were also consuming less stuff; living on less than you make when everyone else is leveraged to the hilt makes you feel poor.  But it's the only way to make sure you survive retirement.