Low Returns, Longevity Mean Greater Retirement Savings Rate Needed

Investors facing inflated asset prices, and the lower expected future returns they imply, must accept the reality that they will need to save more to maintain their lifestyle in retirement, researchers conclude.

In a research report, “Required Retirement Savings Rates Today,” written by David Blanchett, CFA [Chartered Financial Analyst], CFP [Certified Financial Planner], head of retirement research at Morningstar Investment Management LLC; Michael Finke, Ph.D., CFP, dean and chief academic officer at The American College of Financial Services, and Wade Pfau, Ph.D., CFA, a professor of retirement income, also at The American College, say a low-return environment and increases in longevity will affect optimal savings rates for investors.

They created a model to estimate the required savings rate needed to maintain the same level of take-home pay during retirement as the final year before retirement. Optimal savings rates using historical data for households that begin saving at age 25 are between 4.3% for low ($25,000) earners up to 9% for high earners ($250,000). Assuming more realistic returns (low returns) increases the optimal savings rate by 63%, to 7.0%, for low earners and for high earners by 82%, to 16.4%.

The results are even more dramatic if households wait until age 35 or 40 to begin saving for retirement. At 35, optimal savings rates rise to 24.1% in a low-return simulation compared with 14.3% using historical returns for a single worker. If the household waits until age 40, the optimal savings rate rises to 27.5%. Even in a moderate return scenario, optimal savings rates are 24.8% for a single household and 22.8% for a couple.

The researchers note that the risk-free rate on three-month Treasury bills is currently 3.28 percentage points below the historical average (0.21% in 2015 vs. 3.49% between 1928 and 2015), nominal returns on equities in the future are expected to be 3.28 percentage points lower than the arithmetic historical average of 11.41%, assuming the risk premium remains the same.

Future equity returns may then be projected at 8.13% if the equity premium is as high as the historical average.

The report notes that optimal lifetime saving and spending depends on how much the household earns in the future, how long the current wage-earners can expect to live in retirement, and the expected return on savings. Higher investment returns will allow a household to save less and achieve the same amount in retirement. “For example, assume a household earns $50,000 at age 25, expects a 3% annual growth rate in income, and wants $1 million in purchasing power after age 65. If they expect a 5% real return on investments, they will save 10% of their income each year. If they expect 2%, they will need to save 18% of their income each year in order to reach their $1 million goal,” the report says.

A persistent low-return environment will also affect the amount of income a household can expect to receive from savings at retirement. The researchers reveal the amount of income a client can buy using a bond ladder at real interest rates from 0% to 5% for a duration of 30 years (until age 95), 35 years, and 40 years (to age 105). “Savings of $1 million will provide $61,954 of income each year until age 95 at 5%, but only $38,364 at 1%. Funding the ladder to age 100 or 105 not only reduces the income that can be withdrawn each year at 5% ($58,164 and $55,503), but also increase the income spread compared [with] a 1% expected return ($33,667 and $30,154),” the report says.

According to the research report, “A persistently low-return environment thus increases both the percentage of income a client needs to save in order to meet a retirement goal and reduces the income [he] can expect to receive once that goal is reached.”

In addition, the optimal retirement income replacement rate declines if the household’s goal is to smooth annual spending. “While optimal replacement rates at a 6% real portfolio return are near the 70% replacement rate common in planning practice, a 2% real portfolio return will result in optimal replacement rates of 50% with a $100,000 legacy value. At a 0% real portfolio return, the optimal replacement rate is a surprisingly low 31% with a $500,000 legacy goal,” the researchers write.

While retirement is significantly more expensive in a low-return environment, it is even more expensive if a person lives longer. The research notes that the price of a dollar of safe income for a client retiring today is nearly 50% higher than it was for a client retiring in the year 2000 because of increases in longevity and declines in real bond interest rates.

The researchers say annuitization becomes a relatively more attractive option when interest rates are low, because the increase in the cost of building a bond ladder is greater than the increase in the cost of buying an income annuity in a low-rate environment. “With a bond ladder, retirees spend principal and interest. With an income annuity, retirees spend principal, interest and mortality credits, which are the subsidies from the short-lived to the long-lived. With interest low in both situations, the mortality credits become more important. Meanwhile, the low discount rate for the bond ladder makes it increasingly expensive, relatively speaking, to fund spending planned for the distant future,” they write.

According to the report, many investors may be unwilling to accept the lifestyle sacrifices required to save one-quarter of earnings. A reasonable alternative is to delay retirement. “Postponing retirement increases the number of years of savings (and asset growth), reduces expected longevity and increases Social Security income. A couple earning $250,000 would need to each save 26% of income in order to retire at age 60. Delaying retirement to age 70 would reduce the optimal savings rate to a much more palatable 18.7%. The benefits of deferring retirement are even greater in a low-return environment than they would be if historical returns are used to estimate optimal savings rates. A couple using historical rates would need to save only 16.4% of income to retire at age 60 and 12.2% if they retired at age 70,” the report says.

The research report may be downloaded or purchased from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2853538.