We face intense vulnerability regarding our lifetime sequence of market returns. This is an important theme that my research about retirement income planning explores. Market performance in the years just before and after our retirement date has a disproportionate impact on our lifetime financial outcomes. For people who plan and save in the same responsible way, some will be able to sustain a high level of spending over their retirement, while others will not. Strong market returns in the years around the retirement date is fortuitous; we have no control over what these returns will be.
How can you help clients determine if they are retiring at a good time or not? I aim to answer that with my recently developed Retirement Accumulation IndexTM and Retirement Affordability IndexTM. I will update these indices frequently at the new Retirement Dashboard on my website, so that you can better benchmark your clients’ relative situations regarding an upcoming retirement.
Let me explain how those two indices work and how you should use them with clients.
Retirement Wealth Index™
Saving 15% of one's annual salary during the final 30 years before retirement would be a responsible strategy in theory. But in practice, how successful will this strategy be? What would a client’s wealth accumulation be at their 65th birthday? The Retirement Wealth IndexTM provides a basic answer to this question.
The index must be customized for a benchmark client, as obviously each client's personal situation will differ. But the purpose of the index is to highlight the impact of a client’s personalized sequence of returns on their financial success. Advisors who have guided clients toward better outcomes than suggested by the index can also be confident in the value of their services. Though situations will vary, actual client outcomes will at least be correlated with the benchmark retiree in the index. It is either a good time to retire or it is not.
The benchmark retiree saves 15% of their salary each month between their 35th and 65th birthdays. This is a 30-year accumulation period. Salary grows at 1% annually in inflation-adjusted terms from ages 35 to 59, and then stays level in inflation-adjusted terms for the final five years of work through age 64.
This individual invests in a portfolio of large-capitalization stocks (the S&P 500) and 10-year U.S. Treasury bonds. I use the data from Robert Shiller's website to calculate total returns for both the stock and bond indices. I calculate bond returns from their yields assuming a bond mutual fund with equal holdings of 10-year bonds from each of the past 10 years. For asset allocation, I assume that the individual invests in a target-date fund whose by-age asset allocation is the averages in the 2014 Target-Date Series Research Paper by Morningstar. These are the averages across the available target-date fund families in 2013. I use age 65 as the retiree’s target date.
These calculations lead to a stock allocation of 89% at age 35, which gradually decreases to 50% by age 65. Because target-date funds exist only in five-year increments, I make a linear interpolation for asset allocations between each five-year fund date. I also set mutual fund fees equal to the 0.84% average portfolio administration cost as determined by Morningstar in the same report. Taxes are not considered. Figure 1 shows this asset allocation glide path.
Figure 1
Figure 2 shows the wealth accumulations for benchmark retirees turning 65 in each month going back to January 1950. Wealth accumulations are expressed as a multiple of the final pre-retirement salary. These values range from a high of 18.4-times final salary for a retiree on September 1, 2000 to a low of 5.9-times final salary for a retiree on August 1, 1982.
As I will discuss below, those values are less than the 25-times final salary goal implied by William Bengen’s 4% rule.
This index highlights the sequence of returns risk that clients face when saving for retirement. Through no fault of their own, individuals using the same retirement-savings strategy but working and retiring at different times will experience very different outcomes. The 2000 retiree was able to accumulate more than three times that of a 1982 retiree. It's rather shocking.
Where are we today? A benchmark retiree in January 2015 would have accumulated 10.7–times their final salary. Today's retiree is in the 45th percentile of historical accumulations. This means 55% of retirees since 1950 would have made it to retirement with a greater wealth accumulation.
Figure 2
Retirement Affordability Index™
Wealth accumulation is not the whole story. We must also consider how much spending can be sustained by this wealth. We might apply a simple calculation, using the 4% rule to determine how much spending is possible. This assumes that at least a 50% stock allocation is maintained in retirement, according to William Bengen’s historical simulations of spending strategies with different asset allocations. Sustainable inflation-adjusted spending would then be defined as 4% of the retirement-date wealth accumulation.
However, I find such an approach wholly unsatisfactory. Sustainable spending relates to market conditions at retirement. If interest rates are high and stock market valuations look attractive, then a higher sustainable spending rate can be expected. The opposite is the case if interest rates are low or markets appear overvalued.
I will therefore use another relatively simple method to determine the amount of sustainable spending that can be generated by retirement wealth. This approach estimates the amount of sustainable spending that can be supported without taking excessive market risk. A client could potentially spend more by accepting greater market risk in order to seek higher returns. Of course, this could also backfire.
To calculate the Retirement Affordability IndexTM, I will use an annuity formula that assumes retirement wealth must provide sustainable spending over a 30-year horizon and that the retirement portfolio will earn a return equal to the Treasury Department's calculation of the real long-term interest rate at the time of retirement. No further portfolio management fees are charged. The Treasury Department provides the data on long-term real interest rates by calculating the unweighted average of bid real yields on all outstanding TIPS with remaining maturities of more than 10 years. Those data are only available beginning in 2000, which is why Figure 3 begins at a more recent date than Figure 2.
Figure 3 shows the Retirement Affordability IndexTM. With the annuity calculation just described, this index charts the amount of sustainable spending as the gross replacement rate from pre-retirement salary. Larger wealth accumulations and higher interest rates will both contribute to a higher replacement rate, while lower wealth accumulations and lower interest rates contribute to lower replacement rates. As noted, the wealth accumulation for today's retiree is slightly less than average. However, today's low interest rates make it a challenging time to retire. The long-term real interest rate on January 2 was just 0.64%.
Despite saving quite responsibly over a 30-year period, today’s benchmark retiree could only safely replace 38.9% of their pre-retirement salary using the accumulated assets in their financial portfolio. Social Security and other pensions would be added to this, and many retirees will also have their home equity as an asset on their balance sheet. But today's benchmark retiree is not facing the replacement rates levels generally considered sufficient for an enjoyable retirement.
As for the Retirement Affordability IndexTM, a retiree at the start of 2000 enjoyed the highest replacement rate with their savings. It was 105.2%. Though the data are not available to calculate this number for earlier retirees, it is reasonable to conclude based on wealth accumulations and past nominal interest rates that this number was the highest for any retiree in the U.S. historical record. As for the low side, a retiree at the start of 2013 could have only sustained a replacement rate of 33.1% in inflation-adjusted terms for 30 years. Today's retiree is in a bit better shape than this low point but still faces a challenging retirement environment.
Figure 3
The bottom line
The Retirement Wealth IndexTM and Retirement Affordability IndexTM are valuable tools for the retirement planning process. They illustrate the lifetime sequence of returns risk facing clients, and they also identify whether it is a relatively good or bad time to consider retirement. With moderate wealth accumulations and low interest rates, today is a particularly challenging time to transition into retirement. Retiring clients will require help from advisors who understand and can work with the full spectrum of approaches to building a retirement income strategy.
Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at the American College in Bryn Mawr, PA. He is also the director of retirement research for McLean Asset Management and inStream Solutions. He maintains the Retirement Researcher website. See his Google+ profile for more information.
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