An online controversy started when two retirement experts said Mr. Brennan's numbers were wrong. The typical worker was more likely to retire at a much lower standard of living than the 70 percent of final average pay that Social Security and 401(k) plans would deliver. One contrary analysis said 45 percent was more likely than 70 percent.
That's a big difference.
So I'd like to introduce a different approach to the question.
Rather than use the "income replacement rate" commonly used by retirement researchers and financial planners, I suggest examining what level of consumption a worker can have, and sustain, throughout life, starting today. I'll also determine what a worker would have to do, in addition to typical 401(k) plan savings, to achieve that level.
That's what most of us want. We want to be certain we don't retire to a reduced standard of living or, worse, poverty.
The question can be answered using ESPlanner, the next generation of financial planning software. It uses dynamic programming to calculate a smooth path of lifetime consumption spending.
I've used the program to calculate the results for 3 variations on the median 44 year old worker with a $24,000 balance in his 401(k) plan--- the one Mr. Brennan used as his example. Each case assumes an unmarried worker who lives in a no-income-tax state and rents an apartment. The worker enjoys an annualized net investment return of 8.5 percent in a 3 percent inflation environment. The worker started working at 22 and enjoyed annual pay increases of 4 percent a year to age 44. He now earns $59,000 a year. All figures are in dollars of constant purchasing power.
The worker receives no raises for the remainder of his working years. The purchasing power of this workers' earnings will decline from $59,000 at age 44 to only $32,084 at 64. He will put a constant $3,540 into the 401(k) plan and he'll have a declining federal income tax bill.
To create a stable consumption path, he will have to save an additional amount for ten years. The amount declines from $8,532 at age 44 to only $329 at age 54. After that, he'll start to draw down his savings in order to sustain his constant consumption of about $33,984 a year. That's about 57 percent of gross income in the first year.
In the conventional view, which would include income taxes of $3,390, his "income replacement rate" is about 63 percent of his relentlessly flat $59,000 salary just before retiring.
If he saves less, his income and consumption in retirement will be lower. Since few workers would save the additional amount required over their 6 percent 401(k) contributions, the worker is likely to have a lower standard of living after retirement than optimists like EBRI and Brennan expect. As a practical matter, the flat income worker will have trouble long before he actually retires.
The worker receives raises equal to inflation for the remainder of his working years. The purchasing power of this worker's wages will remain at $59,000 from 44 through 64. In addition to putting an inflation-adjusted $3,540 into the 401(k) plan each year, he'll need to save an additional amount each year. This amount rises from $2,357 at age 44 to $7,076 at age 64.
This savings path will help him achieve level lifetime consumption of $40,158 a year. That's 68.1 percent of his starting, and final, income. Add in income taxes of $4,984 and his traditional income replacement rate is a healthy 76.5 percent.
The additional savings required to achieve this starts at 4 percent of income and rises to 12 percent of income. Very, very few workers save this much in addition to a 6 percent 401(k) contribution.
Again, this worker is likely to have a lower standard of living after retirement than optimists like EBRI and Brennan expect.
The worker receives raises that average 1 percent greater than the rate of inflation for the remainder of his working years. The purchasing power of his wages will rise from $59,000 at 44 to $71,991 at 64. His 401(k) plan savings will rise proportionately.
To smooth his consumption, he'll need to save an additional amount that rises from $0 at age 44 to $14,017 at age 64. This will allow him to maintain a constant consumption level of $42,686 a year. That's 72.3 percent of earnings at age 44. Because his real income is rising, his lifetime consumption will be only 59.3 percent of his real final earnings. Again, that's well below the conventional benchmarks of retirement success.
Bottom line: Regardless of future wage gains, workers will have to save more than 9 percent of income (6 percent on their own with a 3 percent employer match). Those who save less, or have a smaller employer match, will have a greater shortfall. Employees who have high expense 401(k) plans that reduce net returns below 8.5 percent will also have a shortfall, as will those whose employer match is company stock that underperforms.
On the web:
Read about consumption smoothing http://www.dallasnews.com/sharedcontent/dws/bus/scottburns/readers/stories/consumption.58f007ab.html
EBRI Issue Brief #283, July 2005
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.
AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.