Many studies show that Americans are woefully behind on their savings for retirement. In fact, according to the 2018 EBRI annual survey, roughly 60% of all workers surveyed have less than $25,000 saved for retirement. But things might not be as bad as they seem.
A recent study by risk management firm Towers Watson attempts to debunk the magnitude of the retirement crisis in America. The authors suggest that most retirees will be better off than predicted, since they don’t require as high a replacement ratio of preretirement income, as what is commonly recommended. They argue that the often quoted rule of thumb that retirees will need to fund 85% of pre-retirement income annually, may be too high. In reality, retirement cash flow needs change over time. As retirees age they move through the “go-go” years, the “slow-go” years, and then the “no-go” years. We spend far less than we anticipate at the end of our lifecycle, due to diminished mobility and health.
In addition, the savings cycle is variable. People will forgo savings early in their career, but ramp savings up substantially in the latter stage of their working years to make up for lost time.
I was recently asked to comment on the Towers Watson study by reporter Mandi Woodruff for an article in Yahoo Finance. My instant reaction to this story was that individual investors have to take these rule-of-thumb numbers with a grain of salt. The data on annual retirement savings is flawed (as the Towers Watson report points out). For example, it does not include the value of pensions, real estate, or closely held businesses. It also does not include the value of transfer payments and other governmental programs, so the resulting data set is incomplete. We cannot draw conclusions based solely on this data.
Gauging retirement readiness should be done on an individual basis. More importantly, as a financial planner who specializes in retirement planning, I know that simple tools or rules of thumb are crude at best. They are like applying blunt machetes in a surgical procedure. They are not going to result in the precision that is needed for each individual’s situation.
The best way to approach retirement planning is to work from the bottom up and determine the clients’ specific personal cash needs and requirements over the balance of their lives. Quick on line calculators and rules such as multiple of final income or spending as a ratio of income can’t possibly apply to everyone. These repeatedly quoted prescriptions for success insinuate that the planning process is static and deterministic, when in fact, it is a dynamic process based on many fluid assumptions and variables. The ever changing-nature of a client’s personal life, tax laws, financial markets, etc. require that the plan is periodically updated.
Instead of a rules based approach, each client should be evaluated in a highly customized and holistic way. That is the essence of true financial planning. It’s not just about investments anymore. It is about how a person will fulfill their dreams and what money can do for them during their lifetime. It is about career planning, lifestyle planning, legacy planning, tax planning, and cash flow planning. More importantly, it also encompasses the “x factor” of a client’s behavior towards and attitudes about money in his or her life.
While many in the field of finance are touting the trend and threat of robo-advisors, holistic retirement planning lends itself far more to the human touch. Since many Baby Boomers are entering the distribution phase of their financial life, customized financial planning is becoming more important than ever.
Proper financial planning starts with an in-depth conversation with a client to better understand what makes him or her tick. It requires listening, attentiveness, and is done best when there is an ongoing relationship with that client. It is not a one and done event.
A detailed retirement plan projection often requires the client answering the following questions:
- What are you needs, wants, and bucket list items in retirement?
- When would you like to retire and how will you phase into the new lifestyle? Will you still want to engage in part time work once you quit your job?
- How will you spend your free time? What might a typical day look like?
- How often will you be travelling and where will you go?
- How often will you be connecting with friends and family?
- Do you want to leave money to heirs or a favorite charity? How will gifts to kids and your charities change upon retirement?
- How healthy are you and do you have a history of longevity in your family?
- How much are you willing to save in order to achieve an early retirement? And conversely, how much are you willing to cut spending before and after retirement, in order to retire early?
- What are your plans for your home? Will you relocate? Will you keep your second home? Will you need any major improvements done? Will you downsize?
- How often will you buy cars and other vehicles? How much will you spend on each vehicle?
These questions not only help to determine annual and overall cash flow needs, they also can help assess behavior around money as well as risk tolerance.
I often use the metaphor of a jigsaw puzzle. Each client walks into my office and figuratively drops the pieces of their life puzzle on my table. Each puzzle picture is uniquely different. It is up to the client and me to put these pieces together to develop a vibrant picture of their future retirement years.
While I think these rules of thumb to assess retirement readiness are not adequate, there are some principles that are highly correlative to retirement readiness.
I suggest that if clients are serious about wealth-building they should save at least 15% of their salary throughout your career and that should limit wealth in personal real estate to no more than 25% of your total assets.
These principles encourage strong savings mentality, keep debt to a minimum, and reduce exposure to a low return asset class (personal real estate). Living below one’s means is a successful way to build wealth and a good lifelong habit. A strong savings rate helps protect against longevity and poor investment returns, as well as having to heavily tilt retirement savings to the back end of a career–which makes the investor more susceptible to market corrections in the years just prior to retirement.
Finally, the personalized, holistic approach to retirement planning addresses the significant challenges that savers have with regard to retirement planning. Having a planner that fully understands these risks and properly accounts for them will help the client feel more confident about his or her prospects for retirement. For example, if the planner assumes conservative investment return assumptions, accounts for higher healthcare cost inflation, adjusts Social Security benefits to account for some reform, assumes a relatively long life span, and the clients still have a high chance of success, they will feel more confident about their upcoming retirement. The peace of mind that is achieved through the financial planning process is something that a rule of thumb or quick on line calculator won’t necessarily provide.
While the savings statistics for Americans suggest significant shortfalls in retirement, working with a planner to determine how to maximize financial opportunities like Social Security and pension maximization, tax reduction strategies, and maximization of their human capital, is essential to preparing for a successful retirement. Ideally, the process is started as early as possible to improve a retiree’s chance of success and ensure that their unique vision of retirement is realized.