By Keith Whitcomb
Remember a few years ago when ING had a "Your Number?" ad campaign? It showed people lugging around bulky six or seven figure number blocks representing how much money they needed to accumulate by the time they retired. The idea was to improve retirement savings by giving individuals a specific goal. Unfortunately, it may have had the opposite effect. The big, seemingly unattainable number, which was relevant perhaps decades in the future, could discourage rather than promote retirement savings.
Improved calculators now communicate estimates in a more meaningful and timely fashion by portraying the target balance as of today instead of when you retire. An example of this approach is the use of savings factors. By simply multiplying your compensation by the factor, you can determine the savings you need today to be on track for retirement. For example, Fidelity uses current age, retirement age, and lifestyle to calculate the factor. The main drawback of these models such as this is their use of over-simplified, one-size-fits-many assumptions. So, while the guidance is perhaps better than showing a big dollar amount needed in the distant future, it's still pretty limited.
A step up from these basic factor models are a number of more sophisticated calculators that allow you to modify numerous inputs to see how changes will impact your funding for retirement. A study by Corporate Insight, "The Looming Problems with Retirement Planners", compared 12 different calculators available from industry giants like Vanguard, Prudential, MassMutual, MetLife, and TIAA. Perhaps the most obvious observation to be drawn from the study is the lack of consistency in the results produced by the models. So, the more calculators you use, the less certain you become regarding saving for retirement? Perhaps, but a more positive way to look at it is that the more calculators you use, the better you understand the variability around the success of your retirement funding based on the combined knowledge of many experts.
A drawback of the more sophisticated calculators is that they revert to evaluating your success at retirement and don't give the immediacy of a compensation factor. They don't answer the "how much do I need today?" question. And while that may not seem like a big deal, determining the funded level today is the process used by actuaries when valuing defined benefit pension plans. You know, the pensions that government and union workers get that make headlines when they are underfunded by billions of dollars? At any rate, there is a simple way to produce a similar evaluation of your retirement funding by using publicly available online calculators. Here's an example of how to do it.
To start, go online and open the T. Rowe Price calculator. This is not meant to be an endorsement of T. Rowe Price (this is one of the calculators reviewed in the "Looming Problems" study referenced above), but merely for the purpose of the demonstrating the process. The same approach can likely be used on many of the other calculators available online. Once loaded, the calculator asks a number of questions grouped as "About You", "Retirement Savings", "Asset Allocation", and "Living in Retirement". After filling in each section, a summary appears showing the amount of estimated income you will need per month at retirement, where you can expect that income to come from, and any surplus or shortfall based on the calculation. If you have a shortfall, go back through the calculator (hit "Next" and then "Start Over") and slightly increase the "Retirement Savings" dollar amount. If you are overfunded, slightly decrease the "Retirement Savings" dollar amount. After a few iterations, you will eventually produce a result that will just satisfy the estimated retirement income. This is the dollar amount you need today to be fully funded.
Once you have calculated the fully funded balance, you can:
Estimate your under- or overfunded balance - Subtract the fully funded amount from what you have actually saved and it produces the dollars you need to put in the account today to be on track for retirement. If you were actually over-funded, you now know by how much.
Determine a funded ratio - Divide your current retirement savings balance by the fully funded dollar amount and you have your funded ratio (multiply it by 100 to present it as a percent).
Calculate your personalized savings factor - Take the fully funded balance amount and divide it by your compensation and you will have a payroll factor that reflects your financial circumstances.
You can use these numbers to help understand or perhaps communicate to a spouse how well you are doing saving for retirement. You can also use these calculations as the basis for budgeting catch-up contributions to improve your funded position. Finally, you can track what the impact of market volatility is on your savings program. If markets go down while you maintain a consistent savings approach, the market impact will show up when you recalculate the factor.
While you now have a better understanding, and a number of ways to communicate how well funded you are for retirement, that's not quite the end of the story.
One problem with these calculators is that they focus on asset accumulation. Completely lacking from all the models is the integration of withdrawal strategies that recognize your unique income needs and the tax profile of your investment portfolio.
Most use generalized assumptions for investment returns and withdrawals. Another approach is to assume the purchase of a single life annuity. Of course, why would financial services firms provide guidance on how to reduce your investment when they are often compensated based on the size of the assets they house?
A classic anecdotal support of this conflict of interest is the "tuppence" scene from the movie Mary Poppins. I don't know what is more entertaining, the portrayal of the bankers, or the mystified looks on the children's faces trying to understand their investment opportunities.
Now that 10,000 boomers are reaching age 65 every day, the industry has begun to focus on retirement income. The result is the discovery that the simple distribution models used in the past to determine funding adequacy do not provide the guidance needed to optimize after-tax retirement income.
Your retirement income needs and the tax profile of your accounts are likely different from the assumptions used by the calculators. To really understand how well your savings program is working, you need to project your liabilities and determine asset harvesting strategies to match. Sound complicated? Well, it can be. Here's a few resources that shed some light on the subject:
Retirement spending assumptions - Unless you are able to map out what you will be spending over the twenty or thirty years of your retirement, consider the use of a "smile" instead the typically employed inflation adjusted constant spend ratio. Here's an article that introduces the concept and shows how significant this assumption can be when planning for retirement.
Account withdrawal strategies - While there are generalized rules of thumb for the order of withdrawing funds from various retirement accounts, this case study shows how an individualized approach can make a big difference in retirement funding adequacy. This reference is associated with a software product available to financial professionals. Once again, this isn't meant to be an endorsement of a product, but rather to let those of you inclined to use spreadsheets to create a solution know that this wheel has already been invented. Here is a white paper from the same company further detailing the approach.
Modifying account location through income harvesting - A problem many retirees will face is an over-weighting of tax deferred accounts (traditional 401(k)s and IRAs). This article describes the basics of harvesting income from taxable accounts to relocate savings into tax free Roth accounts. Determining a taxable/tax-free account mix and then reallocating your funds to achieve it can significantly reduce your taxes and enhance your retirement funding outlook.
Using the tools currently available to produce a personalized compensation factor will get you pointed in the right direction regarding saving for retirement. Adding retirement income needs and portfolio liquidation strategies will fine tune that calculation. Finally, look for more sophisticated tools in the future to help you through this process as the industry further addresses this investor need.
About the author: Keith Whitcomb MBA, RMA is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.