After reading one of my recent posts, a good friend paradoxically asked “What’s a pension anyway?” And his point is well taken – millions of Americans don’t have a traditional defined benefit pension plan or even a defined contribution plan. So how are they going to accumulate enough assets to retire and just how much money will they need to save for retirement?
It seems to me that the average worker is in need of a “Retirement Lifeguard”to help them develop and plan their retirement savings program. Fortunately, Stephen C. Sexauer and Laurence B. Siegel commendably address this issue in their article entitled “A Pension Promise to Oneself” which appeared in theFinancial Analysts Journal, Volume 69 · Number 6 ©2013 CFA Institute: 13-32.
Sexauer and Siegal assuage numerous concerns by saying, “Don’t have a pension? Don’t worry. Most people don’t. They will get to retire, and so will you” (13). And then the authors go on to provide a clear, simple framework for thinking about retirement planning issues and offer a basic “toolkit” to help you get started.
What is “A Pension Promise to Oneself?”
The basic function of any pension or savings plan is to shift consumption over time. In other words, how do you save enough during 45 working years (e.g. ages 20 to 65) to make it last for another 20 to 40 years of retirement? Simply put, one must first accumulate assets by forgoing consumption during the working years and then decumulate the assets, enabling consumption, in retirement. And you may consume what you saved plus (or minus) investment returns (14). Sexauer and Siegal contend that, “with or without your employer’s assistance, you have the ability to make “A Pension Promise to Oneself” and deliver on that promise by making pension payments to yourself from the moment you retire until the end of your life or your spouses life, whichever comes later” (13).
The Personal Pension Plan
In order to create your own Personal Pension Plan the authors outline three basic steps and include examples for a typical high school teacher and sanitation worker given the assumption of “minimum risk investing” which we will discuss later. Here are the 3 basic steps:
(1) Estimate how much annual income you will need during retirement.
For starters, Sexauer and Siegal indicate that this step can be as easy as using a simple rule of thumb like 70% of your pre-retirement income (16). However, I also like to use a “bottoms up” approach by developing an estimated budget of expected future expenses. In this regard, I’d recommend using the U.S. Department of Labor, Employee Benefits Security Administration (EBSA), booklet entitled “Taking the Mystery out of Retirement Planning” which provides a set of easy-to-complete templates.
Then, the authors subtract expected Social Security payments to determine the yearly amount the investor will need to generate from personal savings in retirement. By the way, you can get an estimate of your Social Security benefits by using the Retirement Estimator on the official Social Security website (http://www.ssa.gov/retire2/estimator.htm).
(2) Calculate the “retirement multiple” or total amount of savings to accumulate.
Now the fun part. Sexauer and Siegel reduce the retirement calculation down to a multiplication problem that even a fifth grader can solve (18)! The retirement multiple (RM) is the number of years of income you need to save in order to retire while investing risklessly (or as close to risklessly as markets allow), where “income” is not your current pay but the cash flow you need to generate, over and above Social Security benefits, in retirement. (17) For example, at current market rates, the authors conclude that the retirement multiple RM is 21.47x. So if you need to generate $50,000 per year in retirement then you need to have 21.47 times that amount in assets or $1,073,000 ($50,000 X 21.47 = $1,073,000). (17) {Technical note: The RM is the reciprocal of the DCDB yield: 1 / 4.657% = 21.47 and you can find the DCDB yield at www.dcdbbenchmark.com (18)}
Here’s where the authors’ examples really help to illustrate the methodology.
As shown in Table 1, Sexauer and Siegel (19) project the final (40th year) salary of a Columbus High School Teacher as $79,904 as highlighted in yellow below.
Then, using the 70% retirement income rule-of-thumb discussed earlier, the authors’ determine that the teacher will need $55,933 per year of income in retirement (Line A). Next, deduct expected Social Security Payments of $24,912 per year and we can see that the teacher will need $31,021 (Line C) per year from his/her “Personal Pension Plan.” Finally, by applying the retirement multiple (RM) of 21.47 to this amount we see that the teacher will need to accumulate $666,111 in order to retire (Line E) (19).
(3) Determine the savings rates necessary to accumulate the assets.
The final step is to determine the annual savings rates, and dollar amounts of annual income, that should be saved and invested in minimum-risk investments in order to accumulate $666,419 by the retirement date. In this regard, the authors present a spreadsheet of data for the Columbus High School teacher example that illustrates the assumed growth rates in earnings and annual savings levels necessary to achieve the goal. I’ve illustrated this data in graphical form below. Graph 1, shows that the teacher’s asset accumulation plan successfully achieves $666,419 in accumulated savings after 40 years.
Graph 1: Asset Accumulation Plan
Graph 2, below, provides a closer look at the projected annual income levels and the percentage of income that needs to be saved each year (Annual Savings Rate %) over forty years. Does the percentage of annual income that needs to be saved surprise you? (10% in year 1, 28% in year 20 and 32% in year 40)?
Spoiler Alert: Saving for retirement requires saving a large proportion of your income! “Like dieting, it’s simple to understand but not easy to do (16).”
Graph 2: Annual Income and Annual Savings Rates (%)
In this example, Sexauer and Siegel are conservative in using today’s real risk free rate of return of zero on Treasury Inflation-Protected Securities (TIPS). However, the point is to develop a base case where the investor can guarantee the results and that’s why the “risk minimizing investment” approach is used. In practice, many investors try to reduce the savings burden by taking on “shortfall risk” (the risk of not achieving the asset accumulation goal) by investing in riskier assets like equities with the promise of higher returns. But remember this warning, if the increased risk does not pay off then the investor will ultimately increase the savings burden rather than reduce it (21). And remember, investing in risky assets does not change the retirement multiple or the savings goal one needs to achieve (23).
Sounds simple. Are we done yet?
Not so fast. The truth is that real life is much more complicated than a few simple tables or graphs can depict. As Yogi Berra once said, “It’s tough to make predictions, especially about the future.”
Importantly, Sexauer and Siegel include a thorough discussion about the “adaptive behavior” that’s also required to keep your “Personal Pension Plan” on track. The authors explain that it’s important to make “Personal Fiscal Adjustments” (PFAs) when favorable or unfavorable surprises occur on either side of your balance sheet. These adjustments include increasing or decreasing consumption levels or the production of income. This is really a natural process and people make these types of adaptive changes all the time. For example, parents might move in with their children for a time if necessary. Others might find an opportunity to work full time for a portion of their retirement. The important point is that people can and do make the required adjustments to match needs and resources (15).
Live for Today – Plan for Tomorrow
I really enjoyed Sexauer and Siegel’s pragmatic approach to demystifying the retirement savings problem. They did an outstanding job of simplifying complexity for the average investor and showed that saving for retirement can be done, with limited risk, if you make a simple plan, monitor it and adapt to life’s changing conditions.
I think it’s important to be good stewards of the resources we have and to make sound financial plans for tomorrow. And let’s not forget the bigger picture. Don’t forget to live for today rather than for “retirement.” We aren’t guaranteed tomorrow so live with honesty and integrity, caring for the needs of others and treating others with dignity and respect. It’s much more rewarding to be generous with your time and resources than to build a retirement planning spreadsheet!
Stephen C. Sexauer is the chief investment officer, US multi-asset, at Allianz Global Investors, New York City. Lawrence B. Siegel is the Gary P. Brinson Director of Research at the Research Foundation of CFA Institute, Charlottesville, Virginia.