Thursday, January 7, 2010

Saving for retirement: magic vs reality

Earlier this week, I wrote about the boomers' seriously underfunded retirement savings accounts. My friend Sydney commented (on my Facebook link) that "people living beyond their means and not understanding saving is a huge problem. Not only for the older generation, for which it's too little too late, but the younger generation...who prefer to spend on entertainment, designer labels, and the Starbucks factor rather than saving for homes or putting money away to compound for their retirement."

Sydney is right on, and she and her husband are a very sensible young couple who are making wise decisions for their family and their future. However, she uses one word that worries me: "compound."

What troubles me is that the word "compounding" is often coupled with the word "magic." Google the two words together (or try "compounding" + "miracle"), and you will see what I mean. The idea is that if you reinvest the interest on your initial investment, over time it will grow to dizzying amounts. You can prove this using a simple calculator.

Lots of people believe that this works in the real world as well. They think that if they put a few thousand dollars away every year, especially if they start when they are young, they will eventually have enough for a comfortable retirement. And indeed they might, if they happen to buy in at the beginning of an extended bull market, or if the market consistently expands faster than the rate of inflation, with no serious setbacks.

But they might discover that, despite decades of disciplined saving, they do not have nearly enough. The magic of compounding goes *poof* if inflation roughly equals the growth of their investments, or if a market "correction" or recession cuts their investments' value in half (even for just a year or two), or if their particular funds do poorly; or if they panic when the market tanks and either stop investing or--worse--withdraw their funds; or, sometimes, if they neglect to panic and stubbornly hold on while the market goes completely south...

In real life, some people experience the magic of compounding, while others lose their shirts. I suspect that most of us pretty much get out whatever we've put in, plus inflation. If we invest fairly conservatively, keeping an age-appropriate ratio of stocks to bonds for safety, our investments will somewhat outpace the rate of inflation in good years, enabling us to survive the bad years when the market tanks but inflation continues. At least that's what seems to be happening to the Neffs.

Example: In the late 90s my employer and I contributed a total of $32,766 to a 403(b). I left that job exactly ten years ago and added nothing more to the account, which was nicely balanced among a bond index fund, a stock index fund, a balanced fund, and a growth fund. Over the decade, it went up and it went down and it went back up. Its value today is $38,212. Does that sound good?

Well, let's look at the inflation rate for 2000 to 2009. What you could buy for $100 ten years ago would cost you $129.85 today. This means that what I could have bought with $32,766 ten years ago would cost me $42,547 today--and my magically compounding account holds $4,335 less than that. In buying power, I have been losing money, despite the market recovery of 2009.

My response? Invest more. We've been saving heavily over the last twenty years, because we know we're soon going to need every penny we can squirrel away. We don't expect any magic of compounding. We don't even expect our savings to keep pace with inflation, though we will be pathetically grateful if they do. We just know that if we don't save it, we won't have it.

How much do you need to save for retirement? Short answer: if you work and save for 45 years and are retired for 15 years, you probably need to put away from 1/6 to 1/3 of your income every month. If you work and save for 40 years and are retired for 20 years, you'll need to save from 1/4 to 1/2. (The lower figure assumes that half of your retirement income will come from Social Security; this may be optimistic.) In other words, what you save is what you will get, more or less.

Young people and even some middle-aged people tend to sigh and say, "I guess I'll never retire." Fine, if your health permits and there are jobs available for octogenarians. Not so fine if your company folds or you get Alzheimers or heart disease or cancer.

When Americans traded guaranteed pensions for 401(k)s, we took an enormous gamble--and most of us lost. When independent-minded folks argue that we should not help people who lack the foresight to help themselves, they may not realize the enormous amount of foresight required to self-fund retirement. (A lot of these independent-minded folks are unaware that they themselves have saved far less than they will need.) People who assume that they are going to go on living in the style to which they have become accustomed are in for a big shock.

The facts are becoming increasingly plain. There is no guaranteed magic of compounding, except on spreadsheets. Few people are saving enough to retire without drastically changing their lifestyle. The government is as overspent as the rest of us and is unlikely to be able to solve the problem. The best retirement plan? Save like hell, and figure out how to arrange your furniture attractively in a one-bedroom apartment. Oh, and you might want to be really nice to your kids.


Molly said...

You make some good points that most people don't really realize how inflation affects their investments and are therefore undersaving as a general rule. You also make some good points about volatility in the economy and that it doesn't mean you shouldn't save. However, you're a tad pessimistic here when you indicate that most people see no real growth in investment. You talk about saving for 40 years but use data for 10. Putting aside that most people don't (and shouldn't) invest only in the S&P 500, if you'd invested 40 years ago (1969) it would have grown 32 times to 2009. Inflation was a little more than 5 times in the same period. And this was one of the worst 40 yr periods in the history of the US economy.

Saving 50% or more for retirement is unrealistic for most everybody and probably not necessary. As a culture we need to readjust expectations, but it's not irresponsible to indulge in a few "guilty pleasures."

LaVonne Neff said...

I'm definitely pessimistic about the economy--no argument there. As you well know, if you're the Molly I think you are. And I've seen figures that put the S&P's growth at more than 32 times. BUT.

(1)Mixing stocks & bonds is safer but usually produces a lower return, as you indicate.

(2)Income rises over one's working life, and so should investment amounts (not percentages). That means my household's greatest investments would have come as the stock market was doing its worst. As indeed they did.

(3) I see no reason to believe that our overstretched economy is going to give us a growth spurt in the near future, especially since we no longer make things; we just mostly play games with each other's money. In a stagnant or recessionary economy, people need to change their assumptions.

And yet you are entirely right that almost nobody can save 50%. So what does that mean? Maybe I'll write about that next.

Ron said...


I found your blog via the Sojourner's email newsletter. I do agree with most of what you wrote. However, I would like to pass on some of my experience with 401K versus 5-year laddered CDs.

The best advice I ever got from a financial advisor was about 5-year laddered CDs. This advisor spoke at my wife's employer about 10-11 years ago. He was not associated with their new 403b plan, but offered a free seminar, hoping to get new clients.

We have been saving in both 401K/403b and 5-year laddered CDs. The 5-year laddered CDs have outperformed the 401Ks as far as "compounding".

I am not a financial guru by any means. I am a pretty conservative investor, but did diversify in my 401K between growth stocks, blue chip, stocks, bonds and income funds. I signed up for all 7 of the initially offered funds.

During the past decade, during both recessions, our 5-year laddered CDs kept humming along. The rates I have now are down to between 3% to 5.25% (most are in the 4% - 4.5% range. During the prior recession (dot com bust), we had 5-year CDs that were getting 6-8%.

Just as the housing bubble started to burst in August 2007, I did a direct rollover from one of my 401K (from prior employer) to a 5.25% 5-year CD traditional IRA. That 401K had already lost almost 25% in the dot-com bust, and came back up over the following years. I was not about to lose it "again"! This was probably one of my best moves.

The other thing about these 5-year laddered CDs, is that they are at a credit union. So we pay NO FEEs whatsoever!!! On the other hand, Fidelity takes fees from us, even if the fund prices go way down, so you lose even more.

A few months ago, my wife and I reduced our 401K savings % down to the point where we "still" get the employer match. We now have to pay the taxes on the extra that now shows up on our paycheck. However, we are planning to put more into Roth IRAs than we did before. We also are using the extra to pay off our mortgage sooner (5.35%).

I agree that we just need to "save more". But I am VERY skeptical about Wall Street, even more than I was before. Luckily, I began putting more in Roth IRAs and less in 401K back when President George W. Bush went to Wall Street after the ENRON SCANDAL, and "promised" to clean up things on Wall Street. That was a clear signal to me to get the "heck out of Dodge".

Congress has not yet delivered a Wall Street reform bill. We just can't really trust Standard & Poors, Moody's and Fitch. If the status quo remains, history will repeat itself again, probably before I retire.

The only way to "Invest in Main Street" is to "Divest from Wall Street". That is what we are doing more and more. I am not waiting for Congress to do anything, I am going to eventually divest from Wall Street after I make my losses back on my 401K.

5-year laddered CDs in Roth IRAs! Credit unions now have up to $250K NCUA insurance guarantee (just like FDIC is now $250K).

Right now 3.25% for a 5-year CD is (relatively speaking) pretty good, given the alternatives, in my mind at least. The main benefit is that it is safe. Why "gamble" with your savings on Wall Street if you are not even to the $250K NCUA / FDIC limit?