The Fallacy of Target Retirement Accumulations
Like many Americans, my 35-year old brother has yet to save anything substantial for retirement. After years of brotherly pestering, I’ve finally convinced him it’s time to start. I figure that with 30 years until age 65, he still has time to accumulate a decent nest egg. As a starting point, we looked at an online retirement calculator. According to the calculator, if he saves $2,000 per year, he could hypothetically have about $200,000 by age 65. The calculation included a chart with a pleasing upward trend, as seen below:
This steady rise in savings is based on historical average returns. What happens, however, if markets lag? In 15 years, his accumulation might look like the blue line in the chart below. His new hypothetical account growth is reflected by the dashed line. Under these new hypothetical circumstances, his expected accumulation would be about 34 percent below his original target.
Does this lower expected accumulation mean that my brother will need to rethink everything? Does he need to save more? Plan on working longer? My hope is that, under those circumstances, I’ll convince him to stay the course. Because while markets ebb and flow, they tend to revert toward the average over longer periods.
What happens five years later, at age 55, after a strong bull market has positioned his nest egg above the path originally expected? Now his hypothetical target amount is almost 25 percent above his original target, as illustrated by the brown line in the chart below.
What now? Should he save less? Plan on early retirement? Once again, I hope to convince him to stay the course. Don’t forget that the ups and downs of markets tend to average out over time.
The point is that it’s very unlikely that when he gets to age 65 the nest egg will be exactly at his original target. His original target is the amount he could expect on average if he got to try his working and saving career over and over again 1,000 times. But as an individual with only one chance at this 30-year run, he may end up well above or well below this amount at retirement. In fact, even when we look at his nest egg at age 55 or 60, it’s not necessarily a great indicator of where he’ll end up. A lot can happen to his investments over 5 to 10 years.
As mentioned in my previous post, many folks think about retirement in terms of a target accumulation. There are plenty of personal finance blogs that offer articles such as “what you need to do to get to $1 million.” The best way to get to your target might be to get lucky with market returns. Does that mean you should stop saving when you arrive at that amount? What about when markets lag and we have less than we planned? Do we try to work longer and save more?
Research from Dr. Wade Pfau of the American College of Financial Services suggests that if savings rates are sufficient, neither of these actions has been historically necessary.That is, if you’ve been saving for retirement at a steady pace, using target amounts to time retirement decisions may be misleading.
One important reason why you don’t want to time your retirement decision based on a specific amount of savings is that pre- and post-retirement returns are interrelated. Market returns experienced during the working years and returns experienced in the retirement years tend to average out. This means that if you retire when markets are highly valued, you can expect a period of lower returns. And if you retire when markets are undervalued, the odds are that you’ll be in for a period of higher returns. The ramifications for thinking about retirement are enormous.
Let’s do a thought experiment. Imagine a worker approaching retirement in the late 1990s that benefited from a huge increase in asset prices over the prior decade. This may have encouraged the worker to retire early or to spend a little more than he’d planned. But this could have led to poor outcomes when the bear markets of 2001 and 2008 struck in the early years of retirement.
The opposite end of the spectrum is a worker that approached retirement in the late 1970s. (For the purposes of this thought experiment, assume this worker was more like today’s workers with a 401(k) and without a pension plan). Markets languished during the late 1960s and 1970s, and heading into retirement this worker likely had less than his target. But a strong bull market followed through the 1980s and 1990s. This worker could have been spending an inflation-adjusted 7 percent annually and it would have likely lasted through today.
Dr. Pfau’s work changes the way we think about retirement. Instead of thinking about a target dollar amount as a retirement timing mechanism, we should think about target savings amounts. Dr. Pfau’s work suggests “You don’t have to worry so much about actual wealth accumulation and actual withdrawal rates, as they vary so much over time anyway. But the savings plan should be adhered to regardless of whether it seems one is accumulating either more or less wealth than is needed based on traditional criteria.”
 Stay tuned for an upcoming AIER research report on retirement drawdown strategies that improve on the 4% rule.