Do you need to invest half your paycheck to save for retirement?

This article from CNBC suggests that you need to save nearly half your paycheck in order to provide for retirement.

Is this true? Later, I’ll run the math to find out what this means for you. But first, let’s look at the details.

What does Fidelity say?

The standard advice from Fidelity is that you should save around 15% of your paycheck if you want to retire by 67 and start saving by age 25.

Really this depends on your income. Fidelity present an example where a fictional 25 year old, earning $54,000, retires on $100,000 per year. Of course, your salary may entirely differ as might the results from your investments. However, Fidelity don’t reveal their assumptions for investment returns.  So really its impossible to know if their 15% recommendation is a good one or not.  It also does not take into account multiple goals which is where things get complicated.

A good rule of thumb…

That being said, 15% is likely to be a good rule of thumb if your only investment goal is retirement.  In a previous article, I used the example of Jim, a 25 year old web developer. I showed that even with competing goals, around 16% of his before tax salary would allow him to save sufficiently for retirement.  

This was 16% of his current salary ($80,000).  Obviously, this percentage could be lower over time as his salary increased.  

Save 40% of your income?!

Now another scary element in the CNBC article is that you need to save 40% of your income (they don’t say pre or post tax – this makes a HUGE difference).  This is if you want to live off of half of your final salary.  But again they don’t mention taxes.  Most of us are living on nearly half of our gross salaries already.

Can you live on half of your final salary?

We also need to consider our living costs.  These are likely to be lower than in the past.  If you have paid off your mortgage then you won’t have that to worry about.  Anecdotally, I understand that retirees tend to spend less on clothes, nights out, etc.  I personally can’t imagine partying in the club at 65…

So living on half of your final salary is unlikely to be a challenge for most people.

What do the experts say?

But let’s go back to that scary 40% savings rate.  Apparently, this is based on research from Massachusetts Institute of Technology (MIT).  So, I pulled the original journal article from the National Bureau of Economic Research (NBER) website.  It turns out that the article is only a working paper.  It has not been peer reviewed.  This doesn’t mean that the conclusions are invalid however.  

Only in the worst case scenario…

Now only in the worst cases does this paper suggest that you need save more than 40% of your salary for retirement.  This would be:

1. if you work for 20 years before retirement (unlikely for a millenial).
2. earned a 2% real return
3. purchased an annuity with an income that increases 3% per year

Probably a 3% increase in your annuity is a good thing.  An annuity gives you a guaranteed income for a set period of time.  It is a common investment for retirees.

The size of the income depends on how much you pay for the annuity.  In the study, they assume that this annuity will provide an income equal to half of your final salary before retirement. 

Less than 13% should do it…

However, I think that earning more than 2% per year is achievable.  In fact in the same article, they show that if :

1. you save for 40 years 
2. earn 4%
3. and purchase a 3% annuity

Then you only need to save 12.8% per year to have sufficient money for retirement.  Some distance away from “half your income”.

Future returns mean lower retirement savings

Furthermore, the NBER article suggests that rates of return in the future will be lower than the historical average.  For example, in 1993 they note that payouts from annuities were 9.7%.  This means that if you paid $1m for an annuity in 1993 you would receive $97,000 per year as your retirement income. However in 2013 the annuity payout was 6.3%.  So if you needed to earn that same $97,000 per year from your annuity then you would need to have saved 54% more money!  In other words, instead of saving $1m, you would need to save $1,539,700 over the course of your life.

But do you need to buy an annuity?

So annuity rates have gone down.  This is in itself is perhaps an argument against buying an annuity rather than needing to raise your contributions. Afterall, why save more money to make a poor investment?  Surely there are better options?  No one needs an annuity per se.  Rather, what we look for in retirement is a steady and reliable income stream.  This can be done with income producing investments.  Dividend paying stocks for example.

Should you save for retirement with TIPS?

The authors of the NBER article raise another concern.  They discuss how the return on 20 year Treasury Inflation Protected Securities (TIPS) has fallen from an average of 2.18% in 2004 to 0.75% in 2013.  What are TIPS?  Basically they are bonds that are continually adjusted for inflation.  If inflation goes up, then the bond’s return goes up.  The authors use this as a proxy for the riskless real return.  What does this mean?  Three things:

1. The bond is riskless because it is a United States Treasury (and like the Lannisters, the US Government always pays its debts).
2. When we say “real return” we mean an interest rate that is adjusted for inflation:
   1. For example, when you see the savings rates for a bank savings accounts this is a nominal rate.
   2. A nominal rate is not adjusted for inflation
   3. To get the the real rate we need to subtract the current inflation rate from the nominal rate
   4. If inflation is higher than the nominal rate then we are earning negative interest on our savings.  Not good.
   5. Real rates are most important because they tell us how much we are really earning!
3. If riskless real returns are declining then it will be harder for people to achieve their retirement goals.  To achieve the same level of wealth they will need to save a greater portion of their salaries.

There are many other options

… if you understand the Investment Framework then you know how to build a diversified portfolio…

That being said, I don’t think that many people are relying on TIPS to save for retirement. And if you understand the Investment Framework then you know how to build a diversified portfolio.  The NBER authors call the TIPS return the riskless real return.  By “risk”, they mean the risk of the bond issuer (the US Federal Government) defaulting on the bond.  Or the risk that the US Federal Government will fail to pay you back.  But this is only one risk.  Another risk is that you fail to accumulate enough wealth for your retirement.  You can eliminate default risk and inflation risk with TIPS.  However, you then open yourself up to this accumulation risk.

Can you increase your return?

The authors imply that you could increase your portfolio return.  But this would mean “raising the riskiness” of your portfolio (by adding stocks for example).  There is the risk that the value of your portfolio could fall right before retirement.  However this can be addressed through portfolio diversification.

TIPS also have a number of disadvantages:

• The interest rate is typically lower than standard government bonds
• If the interest rate is adjusted upwards for inflation than the investor will have to pay tax on the adjustment (hardly seems fair when it is just protecting you from a loss)
• If inflation is low then there is no advantage to buying this bond.

Why have real rates gone down?

The authors do not question why real rates have gone down over the past decade.  As I have discussed elsewhere, it is down to quantitative easing. What is quantitative easing?  Its a fancy way of saying “printing money”.  After the financial crisis of 2008 many major banks were facing bankruptcy.  So the main central banks of the world (including the Federal Reserve) cooperated to bail them out.  They did this by printing money and using it to buy the bad debts of the major banks.

A reward for bad behaviour…

This is a sound reward for irresponsible lending.  If you or I did something like this, it would be illegal business cooperation and counterfeiting.  But if the government does it, it’s legal!

…an interest rate is the price of money…

What does this have to do with lower interest rates?  Well, an interest rate is the price of money.  If the supply of money increases (by printing billions of extra dollars) then it’s price will go down.  Hence, the return on TIPS goes down.  And so does the interest rate on your savings account. 

Have you held a savings account over the past 10 years?  Well then, you helped to bail out the banks.  And you have been rewarded with the banks paying you negative interest on your savings.  Effectively, this means that that extra $539,700 that you need to retire, is money that you paid to the bank.  Angry?  You should be.

For these reasons, we are not likely to be investing in TIPS for our retirement.  However, Olivia Mitchell, quoted in the CNBC article, suggests that investment returns in general will be lower than in the past.

Vanguard predicts lower stock returns will impact your retirement

The CNBC article refers to a Vanguard where they predict lower stock market returns in the future.  The long-term historical average for the S&P 500 is around 10%.  For the next 10 years, Vanguard expect returns on US equities to be between 3.5% and 5.5%.  They put this down to the following:

• Increased risk of a major recession
• No further policy changes from the Fed in the near future
• A permanent tariff regime for the US and China
• Tight labor markets
• Mixed outlook for global inflation

Will this really affect your retirement savings?

So are they right? Who knows? Personally, I think they are brave predicting 10 year returns. It’s not clear to me exactly how these things translate into reduced future returns. For example, we had perhaps the worst financial crisis in history in 2008. And then we had the longest bull market in history! The S&P returned 330% over 10 years. That’s an average return of nearly 14% per year!

Does the Fed really help?

I am not convinced that policy changes from the Fed help anything. In fact, I think that the Fed is responsible for all of our economic woes. As I have explained elsewhere, the Fed is responsible for the those low interest rates you receive in your savings accounts. But that’s a topic for another day. The point here is that no further policy changes in the near future doesn’t have to be a reason for returns to be lower in the long term.

“Permanent” tariff regime?

A permanent tariff regime for the US and China? Is anything in trade permanent? Was the last tariff regime permanent? No it wasn’t. And this one won’t be either. Not only that, I have faith in the ingenuity of entrepreneurs to find a way around this. The next president may even reverse these tariffs. I doubt this will hold down US stock returns long term.

Are tight labor markets good or bad?

What to they mean by tight labor markets? Simply, unemployment in the US is at 50 year lows. However, few new jobs are being created. Wages are going up. However, this could mean that lower paid workers are being squeezed out of the workforce. This suggests that a recession is on the books. But again, economies recover. This doesn’t mean that future returns will be lower than in the past.

However it could just mean that that demand for workers is increasing. Hence wages are going up. Is being paid more a bad thing? Well every silver lining has a dark cloud if you’re Vanguard. In sum, this is quite inconclusive.

How can you deal with inflation?

So there’s a mixed outlook for inflation. What does this mean? It could go up or it could go down. This tells us nothing. However, if you want to be forewarned about inflation, watch what the Fed is doing. If they are cutting rates then you can expect inflation. This will slowly filter into the (increased) price for stuff you buy in the store. How do you guard against this? Personally, I keep my savings in gold. Gold is a useful way to protect your savings from inflation.

So have Vanguard convinced us that returns on the stock market will be as low as they say? They haven’t convinced me. Everything they have said here is inconclusive. But even if they are right, does it matter? If you take a long term view of investing, then you do not need to worry about these short term issues. And when you save for retirement, you are investing for the long term.

The bottom line on saving for retirement

So what is the bottom line? Do you need to save half of your paycheck to have enough money for retirement? Well let’s look at the evidence:

1. If you are comfortable with living on half of your gross salary
2. And you save for 40 years (your entire working life) and;
3. You can earn at least 4% per year after adjusting for inflation

Then you only need to save 12.8% per year for your retirement. That is a long way from 40%. And what if you start saving later? Say at 30 or even 40? Then yes you will likely need to raise your contribution amount. Or earn greater than 4% per year. Or both.

Is this doable? Of course it is. But you may have to make greater sacrifices in your spending to make it happen. But you can do it. And I talk about how to do it all the time on this site.

If you are concerned that you have left it too late to save for retirement, get in touch with me. I’m happy to help.

Meanwhile, I will continue to tackle alarmist and inaccurate articles on investment. So check back with me for the next one. See you soon!