This article originally appeared in InvestmentNews on 29 April 2013.
With the crux of the financial crisis finally behind them, many future retirees are at a crossroads. For the Medians, a hypothetical family from the middle of the economic spectrum, the past five years has led them to take a good, hard look at their retirement plans. And while their story is fictitious, it may be eerily similar to your circumstances or those of someone you know.
For some people, what follows is a cautionary tale. For others, it may be a wake-up call.
In 2007, John and Judy Median have a gross income of $50,000 and live in a home with a market value of $250,000 – both quite close to a median demographic profile. Mr. Median was born in 1960, toward the tail end of the baby boom. The Medians contribute 3% of their pay to 401(k) plans, which their employers match dollar-for-dollar at that limit. As with many people facing household budget constraints, to contribute more would pinch current consumption, but contributing any less would mean missing out on free money.
As 2007 comes to a close, the Medians have a total of $75,000 in their combined 401(k) plans – a tad more than the average of $69,000 for that year, according to Fidelity. Their house has increased a bit in value since they purchased it five years back, and they now have equity of 25% of the home’s value, or $62,500. They have a few dollars outside of the house and the 401(k) plans, but these are their principal assets.
The Medians are sitting down with their financial planner, Stan, to look at their future. John says he’d like to retire at 65. Stan takes into account the couple’s income, 401(k) assets, house and projected Social Security benefits. He considers current market rates of interest and the Medians’ monthly mortgage payment. He projects annual salary growth of 4%, home price appreciation of 3% per year and an annualized return on investments of 7.5% – all consistent with his firm’s forecasts.
After running all the numbers, Stan forecasts that when John reaches 65 in 2025, the combined value of both his and Judy’s Social Security benefits and the annuitized value of the 401(k)s will be enough to replace 62% of their projected pre-retirement income. That’s lower than his firm’s recommended 70%-75%, but if he includes and annuitizes the forecasted value of home equity, the sustainable income jumps to 88%, so some combination of their Social Security, 401(k)s and spending out of their accrued home equity will get them to where they want to be. John and Judy leave Stan’s office feeling a bit relieved – they don’t like the idea of having to rely on their house, but they’re comforted that the equity they’ve accrued in it is a backstop. They vow to look for ways to cut back a little and increase their 401(k) contributions, but first they need go to the mall. Judy’s cell phone is a few years old and she’s been hankering for one of those new iPhones that are all the rage.
We revisit our friends the Medians today. The Medians have been meaning to get back to Stan to re-run the numbers on their retirement plan for a while now. They’ve been afraid of what Stan might have to say, but lately the stock market is reaching new highs and house prices seem to be doing OK again. They finally get things together and see Stan. What he has to tell them isn’t pretty. First Stan goes through the 401(k) statements. At the end of 2012, their plan balances are invested in 60% S&P 500 equities and 40% Barclays Aggregate bonds and, rebalanced automatically annually, total just under $98,300 combined. Definitely an increase from where it was in 2007, but it’s a far cry from the $126,000 it was forecast to be. In fact, the gain in the accounts is not much more than the $15,800 in contributions made by the Medians and their employers over the last five years.
The picture for home equity is grimmer still. Stan estimates that the value of the Medians’ house has dropped by about 14%, the same decline for the FHFA sales index over the past 5 1/2 years. Taking into account their mortgage payments and principal paydown, he estimates housing equity of $51,600, or about 24% of the current market value. The sum of the 401(k)s and home equity, at just under $150,000, is just a little better than the $137,500 the Medians had when they last saw Stan, and is quite a bit lower than the $255,000 his 2007 model would have forecast.
Stan’s firm has lowered their growth assumptions and discount rates since 2007. The 30-year Treasury rate is down by some 160 basis points, and they’ve reduced forward-looking expected returns and home price appreciation by 1% each. Assumed salary growth is reduced by 1.5%.
John and Judy brace for the bottom line: In order to get the same maximum replacement of income of 88% between Social Security, 401(k)s and home equity draws, they would need to increase their savings rate to 9% – an increase of 6% over their 3% savings rate. The Medians are stunned. They expected they’d have to save more, but this much more? Stan presents the following chart.
He explains that the savings calculation is a combination of a number of factors, principally:
- Initial conditions: The $150,000 net worth that the Medians have now is a bit more than half the $255,000 they “should” have.
- Growth assumptions: Lower interest rates and growth assumptions mean that each dollar saved now will be worth less at the point John retires – both in its dollar amount then and in the annual value of post-retirement consumption it can provide. Stan also notes that their model solves for savings as a percent of income. Because incomes are expected to grow more slowly given the current economic conditions, the total dollars John will be contributing will as well. If the Medians were to adjust their savings to achieve the previously projected dollar value of consumption, their required savings rate would increase to nearly 40%!
- Time: If you want to retire at a set age, each year that goes by means one less year of future work earning salary and associated savings, and one less year of growth in your assets. Move that age back and, in addition to having the additional savings and compounding, you decrease the time spent drawing down the savings you’ve accumulated. In addition, your Social Security benefits will be higher to take this into account. Instead of increasing their savings, the Medians could choose to retire two years later and have roughly the same percentage of retirement income.
As if the shock to the Medians of increasing their savings rate either 6% or delaying retirement by two years wasn’t enough, Stan lays out some additional potential issues he sees in his firm’s model.
- Social Security: The model assumes Social Security will maintain benefits as the program exists today, which he feels is a tenuous assumption. If Social Security benefits are cut across the board by 20%, the Medians would have to increase their savings by an additional 6% to retire when John is 65 or by 5% if retirement is delayed until 67.
- Longevity: The model is based on current mortality tables and makes no allowance for the potential for increased longevity. Allowing for this would almost certainly increase prescribed savings rates.
- Demography: The model makes no allowance for the fact that the Medians, like most of Stan’s clients, are looking to retire in one large wave with other baby boomers. Stan wonders what the impact of this will be on capital markets and questions whether growth assumptions are conservative enough.
Stan does conclude with some good news: “It looks like given the rebound in housing and your current status on your mortgage, you can probably refi and reduce your monthly payment.” Stan estimates that if the Medians can refinance their current mortgage debt of $163,000 into a 15-year mortgage at a 3% no-fee rate from their current 6.5% rate, they could drop their monthly payments by $135. If they increased their 401(k) savings by that amount, it would cut the current savings shortfall from 6% down to a more manageable 2.5%. They, unlike many, have this option because they never did use their house as an ATM nor refinance their now 10-year-old mortgage.
As the Medians are leaving the office, Stan cautions, “If you delay and rates go up, you could lose the opportunity!”
John and Judy had originally planned to head to the mall to grab a bite at their favorite restaurant. But they find they’ve lost their appetites. They resolve to tighten their belts and eat in more often. Starting now.