Once in a while, I think it is important to revisit our touchstone in the financial advisory business–what is the point of investment management in the first place? I’ve always looked at it as a way to make our clients’ dreams come true, not necessarily in the fantasy sense, but in terms of being financially comfortable and having the freedom not to worry about money constantly. Surveys indicate that the main reason investors save is to meet their retirement goals. Of course, there are often other goals along the way, like buying a house or getting the kids through college, but retirement is the Big Kahuna.
How paradoxical is it, then, that Americans do such a lousy job saving for retirement? According to a recent article on MarketWatch, the current gap between what Americans will need to retire and what they have actually saved is a staggering $6.6 trillion dollars. Yes, trillion with a T. Suddenly saving and getting good investment advice seems a lot more important!
Part of the reason the gap is so big is that most investors never bother to calculate how much money they might actually need to retire! According to Retirement Investigator:
…if you are like 58% of active workers, you haven’t. That’s right, 58% of workers have NEVER tried to calculate what they need to save for a comfortable retirement…
And “only 42% of active workers have ever tried to calculate how much they need… and 8% of those admitted they arrived at their answer by guessing,” reported National Underwriter on April 24, 2006.
For whatever reason, trying to figure out a retirement number must be either baffling or terrifying to investors. (Or maybe they just find it amusing. ING has developed an entire advertising campaign around “the number,” with individuals walking around with bright orange numerical plaques.)
I will de-mystify the process and show a couple of simple calculations to arrive at your retirement number, depending on whether you want to be conservative or minimalist in your estimate. First, let’s define our terms. When I am talking about a conservative approach to a retirement number, I am talking about the pool of capital that would be required to support your required spending on a sustainable basis, while attempting to leave the original capital intact. A minimalist approach simply assumes, as the study in the MarketWatch article did, that you convert all of your savings to an immediate annuity.
Sustainable spending is a tricky concept. Dozens of studies have been performed on historical data that suggest that the proper spending rate is 3 to 5%. A lot of endowments use 4%, for example. In reality, I think the sustainable spending level depends quite heavily on financial conditions at the time. A stock market with a 6% dividend yield is going to support more spending than a market yielding 3%. In other words, I tilt toward a relative calculation first developed by James Garland. He shows that you can generally spend more than just your dividend and interest income, but far less than your total earnings yield. His rule of thumb is that sustainable spending is about 130% of the yield on the major stock indexes. (You can use this link to find the current dividend yield on the major stock indexes.) The current yield on the S&P 500, for example, is now 2.02%, so 130% of that number would be 2.626% (2.02 x 1.3 = 2.626). Garland’s sustainable spending rule will form the basis for our conservative estimate.
The basis of every retirement number is income. The easiest way to calculate a retirement number is to determine what income you need in retirement and work backward from there. Let’s say that you would like to have an income of $50,000 in retirement, in today’s dollars. The calculation of the conservative retirement number is straightforward. First, find your multiplier by dividing your sustainable spending level into 100. At the current time, that would be about 38 (100 / 2.626 = 38.080731). Your retirement number is simply your desired income times the multiplier, which in the example would amount to $1.9 million ($50,000 x 38). This calculation gives you the amount in today’s dollars. You can either adjust it upward for inflation to get a future dollar number, or you can use real returns (nominal returns minus inflation) to determine if you are on track on not. Morningstar’s savings calculator is easy to use. There are literally hundreds of others on the web.
The minimalist approach is a little different. It assumes that you will take all of your savings and convert it to an immediate annuity. In this approach, you aren’t worried about dipping into principal–in fact, you’re liquidating it. On the plus side, it allows you generate more income with the same amount of capital. Again, the easiest way to do this is to back into the number. I used one of the popular annuity websites to do this calculation, assuming a 62-year-old couple in Richmond, Virginia. The desired monthly income would be $4,167 , which is equivalent to our earlier annual income of $50,000. The day I ran it, annuity rates were such that I got a quote for a single-life annuity with no payments to beneficiaries for $707,351 at the low end, all the way up to a joint life annuity with a minimum 20-year payment period for $888,741 at the top end. (Every annuity company will have different rates and some have different income options, including income that grows with inflation.)
What did we learn from this little exercise?
1) Retirement requires a lot of money! We determined that supporting $50,000 of spending requires a capital pool of $700,000 to $1.9 million. If you fiddle around with one of the many retirement calculators for a while, you will quickly realize that…
2) You need a high savings rate to get to your retirement number. Putting a 3% contribution into your 401k isn’t going to do it. Think about 15% as a starting number. Without savings to work with, no amount of investment management can help you.
3) Compounding makes a big difference too. The earlier you start, the more years you have to compound. And your assets will compound much faster when your investment return is high. As you play around with a retirement calculator, it becomes clear that you have to…
4) Invest for growth. Here, we finally get back around to why investment management is important. Low rates of return that barely offset inflation, sustained over long periods of time, will not allow you to reach your retirement number. Nope–you’re going to have to figure out how to intelligently expose your portfolio to return factors (and risk) that will allow you to compound at rates far above inflation, at least for an accumulation portfolio. (Perhaps your risk exposure will need to be reduced when you transition to a distribution portfolio, but that’s another discussion.)
Any proven return factor, rigorously executed, will give you a decent chance of reaching your goals, but we tilt toward a relative strength approach. It has been shown to work within markets–and also across markets and asset classes. That flexibility may prove to be critical in a world where many of the best investment opportunities may not be in the U.S., or maybe not even in equities at all. Relative strength is possibly the most adaptable tool in the investment toolkit.