One of the most annoying things writing about retirement is getting countless surveys from financial service companies telling me how little Americans have saved for retirement.
Whenever these surveys appear in the media or blogosphere, they prompt people to ask the wrong questions: Do I have enough of a lump sum in my 401(k) plan? Am I invested in the wrong mutual funds?
The tandem of questions that I find most important involve 1) how much income will your savings generate and 2) will it be enough to sustain a dignified and comfortable lifestyle in retirement?
Robert Merton, who won the Nobel Prize in economics in 1997, recently pondered these questions in a piece in the Harvard Business Review. He's changed his tune since I last saw him in Boston a few years ago, when he opined that the solution to the retirement crisis was to "raise contribution limits" on 401(k)s.
At the time, I thought that was an ill-conceived statement, since most people never come close to hitting the limits on their retirement plans. Here's what he had to say recently and the questions he raises about the conventional wisdom:
* There's too much focus on investment volatility.
The trouble is that investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful—even misleading.
* You can be too safe in your investment strategy, which means stocks, not bonds.
To understand what that means in commonsense terms, consider a person who plans to live off the income from $1 million invested in T-bills. Suppose he retires in a given year and converts his investments into an inflation-protected annuity with a return of 4% to 5%. He will receive an annual income of $40,000 to $50,000. But now suppose he retires a few years later, when the return on the annuity has dropped to 0.5%. His annual income will now be only $5,000. Yes, the $1 million principal amount was fully insured and protected, but you can see that he cannot possibly live on the amount he will now receive.
* Keep it Simple. Ask questions that you can act on. Nobody knows what the market will return in the future or how long they will live.
The customer need worry about three things only: her retirement income goals, how much she is prepared to contribute from her current income, and how long she plans to work. The only feedback she needs from her plan provider is her probability of achieving her income goals...Suppose the saver learns that she has a 54% chance of achieving her desired income in retirement. Like a high cholesterol number, that relatively low probability serves as a warning. What can she do to improve her outlook? There are only three things: Save more, work longer, or take more risk. These are, therefore, the only decisions a saver needs to think about in the context of retirement.
* Categorize Income Goals. In Merton's view, there are different ways to look at retirement income:
Minimum guaranteed income. Income in this category must be inflation-protected and guaranteed for life, thus shielding the retiree from longevity risk, interest rate fluctuations, and inflation. Government benefits, such as Social Security, and any defined-benefit pensions would be included in this category.
Conservatively flexible income. The more flexible but still relatively safe alternative to annuities is a portfolio of U.S. Treasury Inflation- Protected Securities (“TIPS”) that offer a periodic payout of inflation-protected income for a fixed time horizon, typically the life expectancy of the participant at retirement.
Desired additional income. Many plan participants will find that their targeted mix of guaranteed and conservative incomes, along with nonpension plan personal assets (for instance, their house, bank accounts, and savings deposits), is sufficient to meet all their retirement goals.
There's little doubt you can figure this out on your own, but it involves some skills you may not have. If your company provides unbiased financial advice, that's great, but few do. There are any number of free calculators on the Internet, although they won't give you advice on what you need to do. Nevertheless, it helps to run some simple numbers to see how much money you'll have to live on in retirement.
For example, say you had $100,000 saved up. If you used a 4-percent annual withdrawal rate -- a common rule of thumb in retirement planning -- you'd have $4,000 in annual pre-tax income. Unless the money is pulled out of a Roth IRA, you'd have to pay federal income taxes on that amount. State taxes vary.
Combined with Social Security and other savings and pensions, here's the penultimate question: Will this be enough to maintain a decent lifestyle in retirement? If not, what do you need to do to save more?
If you need the help of an adviser, select a fiduciary who is a certified financial planner, registered investment adviser, certified public accountant or chartered financial analyst who have experience in retirement planning. They should not be selling you any products and only charging you a fee for their time. Avoid brokers and insurance agents.
John F. Wasik is an author, speaker and journalist. His latest book is Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist.
