Planning for the Unexpected: A New Approach to Retirement Savings

Retirement planning is all about The Number. So much emphasis is placed on amassing the right number of dollars for retirement that there was a bestselling book on the subject a few years ago called, you guessed it, The Number.

Here’s the problem with that approach. You can calculate your number down to the penny, but how do you get there? Let’s say I’m five years away from retirement. (I wish!) I invest in a diversified portfolio of stocks and bonds in my 401(k), and I’m saving aggressively. How much money am I going to have in five years?

Who knows? The answer is in the hands of the stock and bond markets. I can increase my chance of hitting my goal by saving more, but how much more? Five years isn’t a long time: I could easily end up with less money than I started with, even using a relatively conservative portfolio.

Is there another way to approach the retirement savings problem? This isn’t an ivory-tower question. For most of us, retirement saving is like a runaway project at work: you can be 90% of the way there and have no idea how long that last 10% is going to take. It’s like trying to walk from Seattle to New York, blindfolded. Can I get a compass?

“Okay,” you might say. “If market fluctuations make retirement planning so hard, let’s take the Invisible Hand out of the equation by investing in low-risk bonds or insurance products.” I am sympathetic to this idea, have written about it before, and will talk to one of its passionate defenders in a moment. But damn, have you looked at treasury bond rates lately? As I write this, you can lock up your money for 30 years and get a real (inflation-adjusted) return of 0.77%. That is the very definition of a hard sell.

Another way

Wade Pfau, a professor of economics at National Graduate Institute for Policy Studies in Tokyo, came up with a different approach and published it in the Journal of Financial Planning.

It’s not a new method of retirement savings: it relies on a diversified stock-and-bond portfolio like you probably already have. It’s a compass for your journey through the investment wilderness: a way of checking your progress without having to make a prediction about future market performance—a prediction that will certainly be wrong. I’m going to explain how it works, but feel free to skip ahead to where I link to a simple table where you can check your own progress.

What Pfau realized is: the market goes up, then it goes down. And vice versa. (Yes, this doesn’t seem like much of a eureka moment, but bear with me.)

Take the case of someone who retired in 1982. Lucky bastard: 1982 was the beginning of one of the biggest, longest bull markets in US history, and our guy can spend freely. But 1982 was also the end of one of the worst bear markets in history. That means our retiree had to save and save and save in order to be able to retire in 1982.

“Sure, the 1982 retiree has a high withdrawal rate, but this isn’t fair because it would have been tough to save enough to retire in 1982,” says Pfau.

So he fused together the ideas of savings rate and withdrawal rate. We start with a data set of market performance from 1871 to 2009. Then we invent a hypothetical retiree. Let’s call her Jane. We know Jane’s age, how much she has saved so far (in terms of a multiple of her salary), how much of her salary she needs to replace from her savings in retirement, and how much she is saving now (again, as a percentage of her salary).

Now we can use Pfau’s tables to ask: What if Jane were saving and retiring at the worst possible time in recorded investment history? At what age could she have retired?

You’re probably lost at this point, so let’s fill Jane out with some actual numbers, Ms. Potato Head-style. Let’s say she’s 55, needs to replace 70% of her salary in retirement, has already saved eight times her salary, and is currently saving 15% of her gross pay. According to the table, Jane could have retired at 68. What if she bumps her savings up to 20%? That knocks five years off her retirement date.

Here are the tables for savers age 35, 45, 50, and 60. (The tables for age 55 are in the original article.)

A dissenting view

The problem with taking a historical perspective, of course, is that the 1000-year storm could hit at any time, and Pfau admits as much in the paper. “Indeed, there is an important caveat that these ‘safe’ strategies are only what would have worked in the worst-case scenario from the past,” he writes. “Future retirees may experience even worse market conditions, and this must always be kept in mind.”

That’s not good enough, says Zvi Bodie, professor of management at Boston University and author of the forthcoming book Risk Less and Prosper. “This is an extreme case of what is called hindsight bias,” says Bodie, who advocates investing your baseline retirement money in low-risk assets. “It’s true he’s never seen a truly disastrous period of security returns in the US. But he sure has hell has seen it in Japan.” (The Japanese stock market is famous for hitting a high of nearly 40,000 in 1989 and then slumping to a small fraction thereof ever since.)

Again, Pfau freely admits this. “In the future we could have a worst worst-case scenario. A black swan,” he says.

Here comes the judge

I’m going to referee this debate. As I said, I’m sympathetic to Bodie’s view that we can achieve more certainty in our retirement planning by investing in safe assets, and to a significant extent, I follow this approach myself.

But it’s an approach few investors are likely to sign up for at the moment, when bond yields are at all-time lows, no matter how good an idea it is. Most people I know invest in a mixture of riskier and safer assets and hope for the best.

For them, Pfau’s tables can’t tell you for sure whether your retirement savings is on track—there’s always that pesky black swan to worry about. But they can tell you if you’re off track. If you’re 35, haven’t saved anything for retirement yet, and need a 50% replacement rate in retirement, you’d better be saving at least 15% of your salary if you’re planning to retire by 66—and that doesn’t take into account investment fees and expenses, emergencies, periods of unemployment, and the like.

Better make it 20%.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.