When we last saw John and Judy Median, our hypothetical late baby-boomers, in the spring of 2013 (“Meet the Medians”), they were sitting down with their financial planner, Stan, to get an assessment of their retirement health for the first time since the 2008 global financial crisis. Revisiting the Medians illustrates the tradeoffs so many workers face in making choices along the path to retirement, and reinforces the hard truth that although asset prices have rebounded since the crisis, early and sometimes difficult commitments to savings still need to be made and adhered to if investors are going to come even close to replacing their income at retirement.
In our initial hypothetical scenario, Stan had presented a sobering view of the damage the financial crisis had done to the Medians’ outlook and strongly recommended that they take advantage of the then-low mortgage rate of 3% to refinance their mortgage and use the annual savings to increase John’s 401(k) contributions from 3% to 6% of pay, as well as annually escalate his contributions by 1% to reach 10% of pay, and save a similar percentage of Judy’s earnings in an IRA.
John and Judy heeded Stan’s plan. Two weeks ago, Judy ran into Stan at the grocery store, and they decided it was time for a checkup. Judy collected all the information Stan requested, and today they are meeting in Stan’s office. After exchanging pleasantries and chit-chat, John gets down to brass tacks: “Stan, give it to us straight. How grim is it?”
Stan blurts out a guffaw of surprise and then explains, “Well, both the equity market and the housing market have been a bit kinder. That plus your increased savings rate make the picture a bit brighter than the last time we met.”
Stan puts a sheet of paper in front of the Medians showing forecasts of incomes and asset values for the year-end 2015 and projections to age 65.
The first graph compares current levels of savings and housing equity to those that were predicted after 2007 and 2012. Stan points out that last year’s income was slightly better than his 2012 forecast, savings were $16,000 ahead of the previous forecast, and home equity was more than $35,000 over forecast, thanks to their accelerated mortgage paydown and roughly 20% housing price appreciation, similar to the FHFA House Price Index for the country as a whole. This sets the base for comparing the current age-65 forecast to the previous one. The Medians’ forecast net worth at 65 is now up more than $100,000 (from $569,000 to $673,000) but is still more than $130,000 lower than the rosy 2007 projections.
Mapping this to a reasonable spending plan, Stan’s model indicates that they could spend about $51,000 per year in retirement from Social Security and retirement savings, up about $1,500 per year from what he projected three years ago. If they tap into their home equity, they could potentially spend up to $69,000 per year – or almost $5,000 more than previously forecast. Forecast sustainable spending is still down notably from the 2007 projections as the asset rebounds are still well short of recovering the 2008–2009 losses and the higher projected growth rates Stan’s firm was assuming prior to the financial crisis.
‘How much income do I need?’
“I’m confused,” Judy says. “I see that projected retirement savings and home equity have gone up a good amount, but our income replacement rates are barely changed. Why?”
“Good catch, Judy! Moving replacement rates meaningfully higher would take higher savings and strong returns. It’s also important to understand that the more your earnings rise, the less is replaced by Social Security benefits.”
“OK, OK, but is 64%–87% good?” asks John. “Don’t I want to replace 100% of my income? How much do I need? And why such a large range?”
Stan explains that the low end of the range is projected Social Security income and retirement savings. The high end includes spending some of their forecast housing equity. But that equity isn’t cash in hand; it’s a safety net that the Medians can fall back on if need arises later in retirement or if they choose to downsize. Stan gives four reasons why they don’t need 100% of pre-retirement income.
- Once the Medians decide to retire, they no longer need to save for retirement. That knocks roughly 10% off the top.
- Once they pay off the mortgage, they’ve pre-paid a good bit of future housing costs, reducing pre-retirement income needs by roughly another 20%.
- Depending on the amount and other sources of income in retirement, Social Security benefits will generally be taxed at a lower rate than their pre-retirement income.
- Retirees can, and generally do, replace some financial expenditure with time – they feel less pressure to spend money to save time. Provided they don’t engage in expensive hobbies, they can further reduce need.
Judy asks, “So do we really need much more than 60%–65% then? Our belts are pretty tight as it is, and between our parents and our kids, I expect to have to provide some financial assistance.”
Judy says that while her parents are in good health and have solid financials and a nice house that is completely paid off, and their daughter is on her own with a good engineering job and a serious boyfriend with a great job, she worries about John’s father and their son.
She explains that John’s father, a widower now 83, moved into a retirement home two years ago, and while he has a pension and Social Security, they don’t cover the cost of the home, so he is rapidly depleting his savings. Each year the retirement home’s cost goes up 8%–10%, much faster than his income. Their son moved back home after finishing college. A history major, he substitute-teaches and works nights as a barista. Living at home allows him to start paying down his student loans, but it may be a while before a full-time teaching spot opens up, so he probably won’t be financially stable enough to move out on his own until a few years after that.
“And, if our daughter’s beau gets his act together to propose, we’re going to have to pick up part of the wedding cost,” John adds.
Stan says he has a number of clients facing similar circumstances ‒ stuck between aging parents who might outlive their resources and kids who cannot afford to leave the nest. While he feels for them, he also tells them they need to be a bit selfish.
“John and Judy, imagine yourselves 25 to 30 years from now. If you under-save now, you might be a greater burden on your children than you’d wished, or at least you’d have to make difficult cuts in your standard of living at a point in time when there is little to cut. Understand that this is only a baseline. If I take a downside case – cut Social Security benefits by the 25% needed to bring the program into fiscal balance and cut long-term growth assumptions on housing and asset markets by 1% each – then your replacement rate would drop by about 15% or you’d have to cut spending by about $11,000 a year. That would really hurt. Also, John, what would happen if you lost your job between now and age 65? Do you think you could replace it at your current income?”
Showing them a graph with the breakdown of replacement rates at two different retirement ages, Stan says, “Another lever you can use is to delay retirement. If we go back to our baseline and change your retirement age to 67 instead of 65, the picture looks a bit better. If you delay retirement two years, you’d be looking at 71%–97% replacement. If my previous downside came to pass, you’d still be able to spend 60%–80% of pre-retirement income.”
John and Judy take a minute to let this sink in. John then sighs and says, “Stan, can you give me some perspective? How are we compared with your other clients? Can you give me a letter grade?”
“Grading on the curve … I’d give you a solid B. You are above average. My A’s are in position to retire pretty comfortably at 65 or sooner. C’s are looking at retiring no earlier than 67, or are looking at working into their early 70s to support lifestyles they’ve become accustomed to, but with relatively little in the way of a safety net.”
“Having been a Median all my life, I guess I should be happy with an above-average B,” John says.
Stan gives a serious look. “I know it’s tough, but you’re in the final years of saving, so I don’t want you to wait another three years before coming to see me. At this point, every two years is good – barring another big market event or a major change to your circumstances. Would you commit to that?”
Judy says, “You bet, even if I have to drag John in kicking and screaming. We need to keep our B, and if we’re lucky, maybe we can raise it to a B+.”