In this December 2018 article, I called attention to the challenges of aiming for a savings target at retirement while taking stock market risk. The prevalent approach of saving a fixed percentage of income every year can miss the retirement target by a wide margin, but adjusting annual savings contributions can run into problems as well. Here, I’ll introduce new ways to measure the performance of pre-retirement strategies, test two new strategies and discuss the potential for more sophisticated approaches.
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I’ll use an example similar to the one from the previous article – a 45-year old with current savings of $340,000 who wishes to retire in 20 years. This individual needs to determine how much to save each year until a retirement that will last 30 years. I’ll also assume that, after paying for basic living expenses, $60,000 is left over each year that can be split between discretionary spending and retirement-savings contributions. I’ll further assume that this individual will have enough sources of post-retirement income from Social Security, pensions, or annuities so that withdrawals from savings can all be used for discretionary spending. One of the goals will be to have similar amounts available for discretionary spending pre- and post-retirement – what economists refer to as consumption smoothing, or simply maintaining the same lifestyle.
As before, I’ll use Monte Carlo simulations to project outcomes based on historical returns adjusted downward to produce arithmetic average real returns of 5% for stocks and 1% for bonds. I’ll assume a 60% stock allocation prior to retirement and 30% after retirement as a target-date approach.
Goal setting
We need to first ask the question: How much should this individual save each year to be consistent with maintaining the same pre- and post-retirement lifestyle? We know the initial savings and expected returns pre-and post-retirement. Using Excel or an HP calculator, we can calculate factors for the future value at retirement of $1 per year in savings and the present value of $1 per year in retirement withdrawals. With some algebra we can determine that savings contributions of $13,385 per year will produce equal discretionary spending pre- and post-retirement. We can also estimate savings at retirement of $1,038,221. These amounts and all amounts that follow will be stated in constant 2019 dollars.
Previous strategies
In my previous article, I showed results for strategies of: (1) fixed real savings contributions and (2) adjusting annual savings contributions to hit a retirement target. Below I show results of repeating this exercise and introduce new performance measures.
The top block shows average savings amounts at retirement from the Monte Carlo simulations for the two strategies and also the range from the 25th to the 75th percentile. For fixed contributions this highlights the problem cited in my previous article – the wide range of outcomes – half the amounts at retirement fall in a $500,000 span and the remainder are spread even more widely. With the fixed retirement target, we can reduce this span to zero, but encounter different problems as shown in block below.
To achieve a fixed retirement target, we see wild swings in the amounts needed to be saved each year. The range between the 25th and 75th percentiles is $43,000, which is extreme in relation to an average of about $14,000. I also provide a measure of the annual volatility of savings contributions – the average absolute value of annual changes – and this is close to $23,000 per year. This is obviously not a feasible strategy.
Read the full article here by Joe Tomlinson, Advisor Perspectives
