We all have heard that the U.S. stock market has historically produced an annualized return of 8%. This 8% is used as the input to calculators, spreadsheets, and other financial planning tools to provide retirement plan participants a recommendation for a savings rate. There’s another number that is frequently used: 10%. This 10% is used so often as an example of savings rate that it has almost become a recommendation. Then there’s 4%. This number suggests taking 4% of your investment portfolio value as income once in retirement. You plug these numbers into a financial planning tool and magic happens. You can retire in comfort with nearly 100% of last year’s income (when including Social Security) and still have money left at death to pass on to your heirs. Magic!
Well, not really. Recordkeepers provide for their plan sponsor clients an annual report that details how well the plan is currently working toward providing income for participants in retirement. In this report, the recordkeeper will work the mathematical magic and provide for you, the plan sponsors, a snapshot of the plan average income replacement ratio, the number of people on track versus not, and other useful information. Please do not take this as a knock on the recordkeepers’ reports. There is value in these reports. However, the value of the reports relies heavily on the methodology and inputs. Taking their reports at face value could lead to bad decisions.
Let’s start with the 8% annualized return for the U.S. stock market. That 8% historical return is derived from the very long history of our then growing industrialized nation. We are now a mature economy with future growth rates that are reasonably expected to be lower than in the early years. Also, the reality of today is that we are living in an interest rate environment that is quite low relative to history. Others would also add that equity valuations are quite high today relative to history. These and other factors suggest a more prudent number is likely lower than 8%. Let’s try 6%. The 100% income replacement ratio drops to about 80%. What about 5% (a number more closely resembling a balanced portfolio of stocks and bonds)? The number drops to 75%. Not so bad in either case as both the 80% and 75% are within the suggested 70% to 100% income replacement ratio range that is often recommended.
The above example is for someone starting at 25 years of age, earning $25,000 that first year and with salary growing at inflation. What if this person instead is earning $65,000 that first year? The magical model now tells us that this participant has an income replacement ratio (including Social Security) of about 54%. This is because Social Security accrues only up to annual income limit, which for 2018 is $128,400. In other words, the more you make, the more you need to save for yourself as Social Security will represent a smaller percentage of your income replacement ratio.
What level of savings rate would a participant making $65,000 that first year need to achieve the same 75% income replacement ratio as that person who is making $25,000? This person would need to save about 18% of income (versus 10%) to achieve that 75% income replacement ratio when withdrawing 4% of portfolio value for retirement income. Now imagine a report that combines all participants, despite the differences in their current salary and general life situation, into a single report and a single average number. Also, understand that these reports only deal with information that the recordkeeper has at their disposal. They do not know whether a participant owns a home, has a mortgage, has outside savings accounts, has student or consumer debt, or a myriad of other facts. In our role as retirement plan consultants, we see these reports from dozens of recordkeepers. The reports are useful and informative. However, they can also be misleading. To maximize the value of the recordkeeper’s analysis, review these on an annual basis and seek trend comparisons. Review your plan figures relative to peers. Most importantly, dig into the methodology and inputs. Do not let the headline numbers lead to changing the plan design without careful consideration of other factors.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice.
Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.