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Your Retirement Account Balance May Mislead You

I recently read an article from CNN Money about how much you should have saved at different ages in order to be prepared for retirement. This is a popular topic in the financial media; the problem is that I’m not sure it’s doing anyone much good. In this case, I find the opening lines to be misleading.

The article starts off: “How much should you have saved for retirement? There’s actually a simple answer to that.”

The article goes on to tell you how much you should have saved at ages 25, 35, 45, 55, and 65 for different levels of income. For example, the article shows that a 35 year-old with $90,000 income should have $135,000 saved. While I think this can be a useful exercise as a back-of-the-napkin estimate, I think that account balances alone can be misleading as to financial preparedness.  There is not a simple answer.

The problem with this simple analysis is that recent market performance is an enormous determinant of your retirement account balance. If the market has recently climbed, as it did from 2009 through 2014, your account balance may be higher than the “suggested” amount. Does this mean you’re over-prepared?

What about the flip side? What if you looked at your balance in 2008, when markets had just suffered many years of poor performance? Your account balance was probably below the suggested amount. Does that mean you were under-prepared?

This simple analysis ignores the fact that periods of low return tend to be followed by periods of higher return, and vice versa. Even if you are saving the right amount for retirement, throughout the course of your life you will be alternatively above or below your target savings amount, depending on when you look.

Let’s do a thought experiment. Assume a worker started saving 12.5 percent of his salary in 1975. He made $20,000 per year in 1975 and his salary increased by 4 percent per year.  He invested in a portfolio of 60 percent stocks and 40 percent bonds, rebalancing monthly with no fees. A 10 percent annualized return would hypothetically give this worker almost exactly $1,000,000 at retirement. But what would have actually happened during this period of 35 years?

The chart below looks at his hypothetical accumulation against his actual accumulation. During the 1980’s and 1990’s, soaring stock markets would have buoyed his portfolio well above his hypothetical accumulation. In 1999, he would have at least 60 percent more in his account that his hypothetical accumulation. If he were to look up how much he “needed” to save for retirement, he would find that he was far outpacing the suggested threshold with 10 years left to save.

You know what happened next. The tech bubble popped in 2000, the financial crisis hit in 2008 and markets provided little return over those next 10 years. In fact, by the time he wanted to retire in 2009, he was 12 percent below his hypothetical accumulation.

Was he over-prepared in 1999? Not really. Was he under-prepared in 2009? Not really. In fact, if he retired in 2009 and maintained his stock exposure over the first 5 years of retirement, he is probably right back on track with his long-term plan.

During the course of his working career he could have looked at his balance and thought he was alternatively over- or under-prepared (mostly over-prepared in this example). The balance itself would have been misleading. The important measure was not his balance, but whether he was saving an adequate percentage of his income.

The ups and downs of markets tend to average out over time. As research has shown, workers may want to think about a target savings amount instead of a target dollar amount by age. That’s more within the realm of what you can control.

account balance example (3)

Sources: Pfau, De Santis and Lee

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