A low-return outlook and increasing lifespans mean investors will need significant savings rates to fund retirements.
By David Blanchett, Michael Finke, and Wade Pfau
Advisors often need to make assumptions about future asset returns in order to estimate how much an investor may need to save today in order to meet retirement-spending goals. We generally look to the past to project the future, but higher prices for stocks and bonds today suggest that investors can likely expect lower returns. Higher-earning Americans are also living longer, increasing the cost of funding a retirement income goal. It is important for advisors to recognize the planning implications of funding a longer retirement in a low-return environment.
Using a lifecycle model in which households maximize utility by smoothing spending over time, we find that households will need to save significantly more in order to maintain their lifestyle in retirement. Even when we incorporate Social Security, taxes, and a decreasing retirement spending path, a 25-year-old worker earning $100,000 a year will need to save 40% more each year if we project returns consistent with today’s stock and bond valuations with expected increases in longevity. Higher savings rates and increasing longevity also mean lower optimal spending across a lifetime and higher costs of leaving a legacy.
Our findings imply that planning tools should strive to give planners the flexibility to incorporate lower potential returns, and that employers should consider higher default savings rates and auto-escalation in defined-contribution plans to increase participant savings rates if low returns persist.
The Double Whammy of Low Returns, Longevity
Optimal lifetime saving and spending depend on future earnings, years in retirement (a combination of retirement age and longevity), and expected investment returns. Higher investment returns can allow a household to save less and earn more income 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 need to save 10% each year to reach their goal. However, if the return expectation drops to 2%, they will need to save 18% every year until retirement to reach the same goal. Similarly, real retirement income on that same pot would be about $50,000 a year with 5% returns or $20,000 with 2% average gains. More on retirement income in a bit.
How much lower could returns be in the future? First, when considering the implications of a low-return environment, it is important to remember that the expected portfolio returns are net of inflation and any investment expenses. Given today’s negative bond returns net of asset management fees (average 1%) and inflation (0.73% in 2015), and expected real equity returns of perhaps 2% to 4% net of asset fees, it is important to understand the planning consequences of a future with 0% to 2% real portfolio return.
People are also living longer. This is generally good news, but it does make retirement more expensive. Life expectancies for older Americans have increased considerably over the past 100 years and are projected to continue increasing. Men and women who reach age 65 in the United States are expected to live to 86 and 89, respectively, by 2100—up from 81 and 84 in 2000 and 76 and 77 in 1900, according to the Social Security Administration.1
Longevity doesn’t treat people equally, however. Higher-income (and higher-wealth) households are living significantly longer than lower-income (and less-wealthy) households. For example, a man in the top income percentile is expected to live three years longer than a man with a median household income, based on data from the Health Inequality Project.2The same figure for wealthy women is four years.