How Much Do You Need to Accumulate?

One of the surest ways to cause an anxiety attack is to ask someone (or yourself), how much they need to save for retirement. The panic most people feel when they hear this question is triggered by some combination of three underlying fears most of us have: Either we will outlive our retirement savings, we'll see our purchasing power severely eroded by inflation, and/or we won't end up leaving as much money to our heirs as we'd like. One of the best ways to overcome these fears is to better understand the issues and trade-offs that underlie them. (Read more, or or go to our calculator at the end of this section.)

Saving for retirement is an issue that is not only very important, but also one that too many people don't understand as well as they should. Back in 2001, the United States Retirement Confidence Survey found that while 67 percent of current workers report that they have saved something for their retirement, only 32 percent had tried to calculate how much money they actually will need to have saved so that they can live comfortably after they retire. Given this, it comes as no surprise that only 23 percent of current workers believed they were doing a good job of preparing financially for their retirement. And after the tremendous destruction of wealth in 2008, even fewer probably believe that today.

Why haven't more people tried to calculate how much money they need to save to pay for the retirement they want to enjoy? Former Federal Reserve Chairman Alan Greenspan suggested one reason, when he noted in one of his appearances before the U.S. Congress that "one of the most complex economic calculations that most workers will ever undertake is without doubt deciding how much to save for retirement." In short, many people may simply find the calculation too difficult to do on their own. Academic research by Professor Annamaria Lusardi has also suggested another potential explanation: people are afraid of what they may find out.

Avoiding this issue, however, may only compound future problems. Using data from the Health and Retirement Study, Professor Lusardi found that 54 percent of retirees who had not planned for their retirement rated their retirement years as not as good as their working years, while 79 percent who had thought a lot about retirement rated it as better or about the same as their working years. In summary, the data suggest that, painful or not, understanding how much we need to accumulate for our retirement (and what we need to do to get there) is an issue that all of us are better off confronting now rather than putting off until later.

Here is the way we approach it. The first question to ask is how much annual income will you need to have the lifestyle you want after you retire? To make things easier, this entire discussion will be in so-called "real" terms, assuming the effects of inflation have been removed. For example, a number of studies suggest that people generally desire replace 70% to 90% of their pre-retirement income. If we assume that amounts to $100,000 today, a target post-retirement income might be $80,000.

The second step is to subtract from this the annual income an investor expects to receive from non-portfolio sources, including a state pension (e.g., Social Security in the United States), a company pension (if you are in a defined benefit plan) and part-time work. Let's say these sources amount to $30,000. That leaves $50,000 in annual income (i.e., $80,000 less $30,000) that our investor's portfolio of financial assets must provide after he or she retires.

The third step is to determine the size of the bequest, if any, that our investor wants to leave after he or she dies (and note that for many people, this target bequest also serves as precautionary savings for unanticipated health care costs not covered by insurance). One way to think of this is in terms of a multiple of your annual portfolio income. Let's say, for example, that our investor wants to leave a bequest equal to ten times his or her annual portfolio income, or $500,000.

The fourth step is to estimate the number of years the investor expects to live in retirement. A "mortality table" (our tables come from the U.S. Internal Revenue Service, the national tax authority) provides the expected years of remaining life for people at different ages. However, these estimates are simply the midpoints of distributions that can be quite wide; some people will die sooner than the mortality table's estimate, while some people will dies later. Interestingly enough, other researchers have found that individual's own estimates of their remaining years of life are often more accurate than a simple random guess (probably because they are based on a knowledge of family and personal health histories). In this example, we will use an estimate of 25 years of life to be spent in retirement.

The fifth step is to estimate the real (after inflation) compound rate of return an investor will earn on his or her financial investment portfolio after retirement. In this example, we will use 4%.

Armed with these estimates, you can calculate the real value (i.e., the value in today's dollars, or whatever currency you are using) of the amount of money an investor must accumulate by the time he or she retires, in order to meet his or her expected needs.

The actual calculation is a two-part process. The first discounts a 25 year stream of $50,000 payments at 4% to their present value of $781,104. The second discounts a one-time payment of $500,000 at the end of 25 years at 4% to its present value of $187,558. Adding these two together yields an accumulation goal (in today's dollars) of $968,662.

Of course, this analysis has some important caveats. The first is based on a common fear: "but what if I live longer than 25 years after I retire?" Technically, this is called "longevity risk;" practically it is called "outliving your savings." There are four ways to manage this risk. The easiest is buy longevity risk insurance. Products which offer longevity insurance are known as "annuities." Annuities promise to make payments to you over some period of time. These payments can be either fixed (i.e., not increase with inflation to keep their real value constant) or variable (i.e., payments rise with inflation). By investing in a real annuity, you avoid the risk of having inflation erode the purchasing power of your income over time. Hence, in this article, we focus only on real return (inflation indexed) annuities.

The simplest inflation-indexed annuity promises to pay you a fixed real income for as long as you live. More complicated products will also make payments for a period of time after you die (e.g. until a spouse dies). However, annuities come with two potential costs: first, they require a large up front premium payment, which is not available for use as a bequest if you die earlier than you expect. While annuities that guarantee a payout for a minimum number of years to some extent limit this potential cost, the financial consequences of dying too soon have caused many people to decide against purchasing an annuity and instead look for other ways to manage longevity risk. Second, as the 2008 crisis made clear, since annuities are issued by insurance companies, they also carry some amount of credit risk. If the issuing insurance company goes bust, there may be little or no payout under the annuity (though there has yet to be a major insurance company bankruptcy where we have seen how this scenario would actually play out).

The second way to hedge the risk of outliving one's assets is to use a long expected life in your calculations. However, this has two potentially adverse consequences: it leads to a higher accumulation goal (which implies reduced consumption before you retire), and, if you die sooner than expected, it results in a higher than desired bequest.

The third way to manage longevity risk is to use your bequest goal as a buffer, drawing it down if you live longer than expected. Of course, this means that, depending on the returns you earn on your investments after retirement, you may not achieve your bequest goal if you live longer than you expect.

The fourth way to manage longevity risk is to assume a relatively low real rate of return on your investments after you retire. The lower the assumed rate of return, the easier it is to achieve. We believe that the four percent real compound rate of return we have assumed in our example is prudent for someone with a normal risk preference. Expected real rates of return above this would, in our estimation, imply a higher than normal tolerance for investment risk, as well as a higher probability of not achieving one's portfolio income and bequest goals.

The second caveat is that this analysis does not explicitly take into account residential property owned by an investor. This is because different investors will treat this in different ways. For example, one investor may enter into a "reverse mortgage" to generate post-retirement income that does not depend on the returns on her investment portfolio. Another may sell his large house, purchase a smaller one, and add the profits realized (technically the "equity extraction") to his financial investment portfolio. And still another may consider her house as her bequest, and thereby reduce the size of the bequest she expects her financial investment portfolio to fund.Ê

Determine Your Accumulation Goal

With these caveats in mind, the following pull-down menus show how the interaction of the expected years in retirement and the size of the bequest goal interact to generate different accumulation requirements:

We assume a four percent real compound annual return on the financial portfolio after retirement.
We also assume an annual portfolio income goal equal to 1,000 (which makes it easy to scale the result to different income goals).
Two inputs are required. The first is the number of years a person expects to live after his or her retirement. The second is the size of the bequest goal he or she expects the financial investment portfolio to fund, expressed as a multiple of the annual income he or she expects the portfolio to produce,
The resulting accumulation requirement is expresses as a multiple of the annual income goal. For example, a person who expects to live 25 years after retirement, with a bequest goal equal to ten times his or her annual portfolio income goal, would have an accumulation requirement equal to 19.4 times the annual income goal. So, if the annual income goal was $50,000, the bequest goal would be $500,000 and the accumulation requirement would be $968,662.

This result raises two critical issues. The first is how to accumulate this amount of money by the time you retire. We show subscribers to The Index Investor how different combinations of of annual savings, asset allocation, and rebalancing strategies affect the probability of achieving different portfolio long-term real rates of return (and accumulation goals) over different target time frames. As you can see, investors face a complicated set of trade-offs between desired accumulation goals, savings rates, time to retirement, and acceptable levels of risk (i.e., the probability of falling short of one's goals, and the potential size of this shortfall, should it occur). Indeed, most investors probably have in their head two scenarios: one ideal, and one that is the minimum outcome that is acceptable to them. We do not believe that there is any single "right" way to make these tradeoffs - investors differ in too many ways. What we do believe is that investors who explicitly explore these tradeoffs, and make logical, well informed decisions about them, are likely to feel much less anxious and ultimately much more satisfied with the results they achieve.

The second critical issue is how to achieve the post-retirement real returns needed to meet your portfolio retirement income and bequest goals. We cover these issues in our sister publication, Retired Investor.

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We provide more detailed quantitative analysis of the "how much do I need to accumulate?" issue in our monthly journal -- The Index Investor at a cost of U.S. $195 for one year. Subscribe to The Index Investor

Now that you know how much you need to accumulate, you have to evaluate the different paths you can take to achieve that goal. Broadly speaking, you have two choices: a lower savings rate and riskier asset allocation in your portfolio, or a higher savings rate and more conservative asset allocation policy. Lower savings mean that the required rate of return you need to earn to achieve your accumulation goal will be higher; higher savings mean that your required rate of return will be lower. So let's move on to the key to our section Asset Allocation is the Key.

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Expected Years In Retirement	Bequest Goal as Multiple of Annual Portfolio Income Goal