How much do you need to fund retirement? More than you think

Don’t shoot the researchers.

Yes, a new study indicates that those saving for retirement will need to increase dramatically the percent they save for retirement if they want to fund their desired standard of living in retirement.

Consider: Americans presently save on average 5.5% and 401(k) plan participants deferred, on average, 6.8% of their salaries into retirement plans in 2015. But those savings rates are far below what’s needed to fund retirement given today’s markets, according to the researchers, David Blanchett, head of retirement research at Morningstar Investment Management, Michael Finke, dean and chief academic officer at The American College of Financial Services, and Wade Pfau, a professor of retirement income at The American College of Financial Services.

Indeed, the researchers showed that a 35-year-old couple with household income of $50,000 would need to save pre-tax about 11.1% to 13.1% to maintain their standard of living while the same couple with household income of $100,000 would need to save 13.4% to 16.8%.

What gives? Several factors are to blame.

Low future investment returns

Valuations on risky assets (stocks) are high and yields on safe assets (bonds) are low. And that, the researchers say, portends an era of lower expected returns in the future. What’s more, the researchers say high asset prices and expected lower returns affect the relative cost of funding financial goals.

“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,” the researchers wrote in their report, Required Retirement Savings Rates Today. “If they expect a 5% real return on investments, they will save 10% of their income each year. If they expect 2%, they will need to save 18% of their income each year to reach their $1 million goal.”

Retirement income lower, too

The researchers also note that a persistently low-return environment not only increases the percentage of income a person needs to save to meet a retirement goal but it also reduces the income a person can expect to receive once that goal is reached.

For instance, a 35-year-old who earns $50,000 and who will experience real wage growth of 1% per year for a 30-year career, followed by a 30-year retirement could drawdown, assuming a real return of 0%, just $28,988 per year compared to $46,938 with a 6% expected rate of return.

“For savers, lower returns mean less spending across the life cycle,” said Finke, a co-author of the report “They spend less during their working years because they need to save more. During retirement, their goal should be to spend about the same as they did during their working years. Even though they’ll be spending less, they need an even higher nest egg when investment returns are low. There’s really nothing good about low returns if you’re a saver. If you’re a borrower, it’s great news.”

Longevity makes retirement more expensive, too

That life expectancies for older Americans has increased over the last 100 years and are projected to continue increasing isn’t helping those saving for retirement either.

“Today’s workers who expect to retire at the same age as retirees in previous generations will face an even greater cost of funding retirement because of increases in longevity after the age of 65,” the researchers wrote. “Retirement is significantly more expensive in a low-return environment, but it is even more expensive if a person lives longer.”

In fact, the researchers calculated that the price of a dollar of safe income for a person retiring today is nearly 100% higher (or twice as high today) than it was for a person retiring in the year 2000 because of increases in longevity and declines in real bond interest rates.

“Not only are investors getting less return on their safe bond investments,” notes Finke. “They’re also living longer, so they need to fund more years of spending. The bottom line is that retirement is just more expensive today than it was in the past.”

Legacy goals are expensive, too

The researchers also note that trying to create a sum of money to pass down, to bequest, to loved ones and others on top of funding a desired lifestyle in retirement is also quite expensive in a high asset price/low expected returns world.

“For those who want to leave $500,000 to their heirs, they’ll simply need to save more," says Finke. "Low rates also increase the cost of buying a life insurance policy to fund a legacy.”

So, what are savers to do in this low-return, long-longevity world?

• Use lower expected rates of return when calculating how much you need to save for retirement and how much income you’ll be able to draw down once in retirement
• Consider increasing sharply the amount you save now (that means lowering your current standard of living) to fund your desired standard of living in retirement.
• Consider using an income annuity instead of using a bond ladder for your safe assets? Why so? The researchers suggest that annuitization becomes a relatively more attractive option when interest rates are low. “This is because the increase in the cost of building a bond ladder is greater than the increase in the cost of buying an income annuity in a low-rate environment," the researchers wrote. “With a bond ladder, retirees spend principal and interest. With an income annuity, retirees spend principal, interest, and mortality credits, which are the subsidies from the short-lived to the long-lived. With interest low in both situations, the mortality credits become more important.”
• High earners need to save even more than low earners to fund their desired standard of living. For instance, a single 40-year-old person earning $50,000 would need to save 19.4% in a low-return world to fund a desired lifestyle in retirement while that same person earning $100,000 would need to save 25.6%.
• Retiring later, at age 70, lowers the percent you need to save. For instance, a single 35-year-old person with household income of $50,000 who wants to retire at 60 needs to save 19.1% per year to fund their desired lifestyle in retirement, or 15.8% if they want to retire at 65, or 10.6% if they want to retire at 70.

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch. Got questions about money? Email Bob at rpowell@allthingsretirement.com.