What’s a Year of Work Worth?

A reader has raised a good question. What’s it likely to be worth to your retirement income if you delay retirement and work another year? This is a popular concept for those baby boomers on the cusp of retirement whose retirement savings have been decimated by the recent market collapses. Let’s look at a number of factors and see how you might project an answer. I’ll use an example.

Example. Ernie (remember him from January 16’s post?) was planning to retire in 2009. He had saved enough—he thought—to replicate his working-years’ lifestyle, taking into account Social Security, some common expense adjustments, etc. His savings goal had been $1,198,750, but last year, instead of growing his savings buckets by 4.5%, the buckets shrank by 33%, leaving him with $767,000. Ernie had planned for his savings buckets to provide $47,950 of his retirement spending, which is 48% of his $100,000 salary. (Ernie is using the 4% Plan as his retirement spending plan, as described in January 13’s post.) But now he’s far short of his original goal; he only has enough for $30,680 ($767,000 x 4%), which is $17,270 short of his annual spending goal. That's a big deficit. How much of it can he make up by working a year? Let’s look at some of the factors, and see if we can ballpark a projection.

I’ll try to express all factors in terms of a common yardstick, to get a sense of how important each factor is to Ernie’s retirement security. I’ll use Ernie’s $100,000 salary as a common yardstick. Salary is a good choice, since it’s a number one can easily relate to. So Ernie’s $17,270 spending shortfall is 17.3% of his salary. How much of that can he make up with a year of work?

A Year of Investment Return. By delaying a year, Ernie’s savings buckets grow by a year’s worth of investment returns. In Ernie’s case, he projects that to be 4.5%. That will make up $1,381 of his spending shortfall, which is 1.38% of his salary. This is one of the bigger factors he will benefit from with his year of work. But remember, little things add up.

Where did those figures come from? To get his projection of 4.5% real (inflation-adjusted) return, Ernie applied historical averages to his asset allocation (50% equities and 50% fixed income), and reduced the result by historical average inflation. What?! You don’t think historical averages make sense in today’s environment? Well, what’s your prediction, Kreskin?

Since Ernie’s using the 4% Plan to translate savings into retirement spending, he multiplies his 4.5% growth by 4% to translate that into how much additional retirement spending he can generate after a year—the equivalent of 0.18% of his savings bucket; which, as I said, is 1.38% of gross salary in Ernie’s case.

A Year of Reduced Life Expectancy. By working another year, your life expectancy is reduced by a year, which ought to translate into a slightly increased spending rate. You don’t know how long you’re going to live, but you do know it’s going to be one year less a year from now. Maybe even less, if your job is particularly taxing. Or you’re an ice-road trucker. In Ernie’s case, however, he is using the 4% Plan, which fails to take this factor into account—one of the things I don’t like about it. But if you are using the 4% Plan, then you too should ignore this factor.

You can nonetheless project what this factor might be worth. One way to ballpark it is to consult your insurance advisor—or do this yourself on the internet—and see how the cost of an annuity (or a joint and survivor annuity if you're married) drops for someone who is one year older. Not that you’ll necessarily buy an annuity; but the relative costs provide a measure of the benefit of waiting a year. Ideally, you’ll price inflation-adjusted annuities to get a more realistic idea.

Or perhaps you employ a retirement spending method that does take into account your ever-shrinking life expectancy. One such plan starts out with distributions of 6% of your savings buckets at age 65, and then that percentage grows by 0.067% per year until it reaches 8% at age 95 (where it remains no matter how ancient you get). If Ernie were using that retirement spending plan, he would project a retirement spending benefit of 0.067% of his savings buckets, or $511 per year. That works out to 0.511% of his $100,000 salary.

A Year of Personal Retirement Savings. By working a year, you can add some savings to your savings buckets. For example, since Ernie uses the 4% Plan, he projects that every $100 he saves this year picks up $4 of his retirement shortfall. Another way to look at that is that every 1% of salary he saves makes up 0.04% of his salary of his 17.3% spending shortfall. Unfortunately, this close to retirement, adding to savings, while necessary, just doesn’t go that far.

How much should Ernie save in this last year? Good question. The wrong answer is for him to continue at whatever rate he’d been saving. Let’s say Ernie has a $100,000 salary and in recent years has been saving a percentage that he recalculated each year, and which worked out to be 8.4%, or $8,426 (see January 22’s post). Should he save $8,426 this year? No. Things change, and 2008 was a year of big changes. Remember the primary principle: you want to treat the Future You and the Present You equally. So you (and Ernie) should increase your savings this year to an amount that brings your current spending down to your new, unfortunately reduced, projected lifestyle. I’ll get back to this in a minute.

A Year of Employer Contribution to Your Savings. If you work for a company that matches your personal savings to some degree, then you can figure that your employer will add something during this year of additional work. (Although the press reports that a lot of employers are dropping their matching contributions in 2009 in light of the uncertain economy, the cheapskates.) Ernie’s employer has historically matched 50% of his contribution. But only up to a limit; i.e., only counting savings of up to 6% of his salary. So he figures his employer contribution will be $3,000, which will increase his retirement income by $120. That works out to 0.12% of his salary (50% x 60% x 4%).

Social Security Actuarial Increase. Part of your—and Ernie’s—retirement income comes from Social Security. Ernie’s benefit happens to be $18,000, which works out to be 18% of his $100,000 salary. By waiting a year to start taking Social Security, he gets an actuarial increase of 8% in his benefit, which works out to be 1.44% of his salary (18% x 8%), or $1,440. It turns out that this is the single biggest factor in helping to make up Ernie’s 17.3% shortfall.

Social Security Benefit Increase. If Ernie follows the typical career pattern of increasing compensation, another year of work will increase his average salary on which his social security benefit is computed. This is a tough factor to ballpark, however, since the formula for computing benefits is so complicated. It’s based on a 35-year average wage history; and to make it more complicated, your prior years’ wages are hypothetically increased by changes in the average wages paid to all U.S. workers. You can go on the Social Security website and use their calculators to see what another year of high salary might mean for you. In Ernie’s case, based on his whole career’s wage history, he figures one more high-earning year will cause an early-career low-earning year to drop out of the calculation, and increase his benefit by about $333, or 0.33% of his salary.

Pension Increase. If your employer is one of the shrinking pool that still offers a traditional pension plan, another year of work might increase your pension benefit in up to three ways. Since pension plans vary greatly in design, it’s hard to say anything concrete, but here are three potential ways in which you might benefit:
• Credit for another year of service if you haven’t already reached the maximum number of years counted under your plan.
• If your next year’s salary is higher than your average, that could increase your pension. In lieu of the wage-indexing that Social Security employs, many private pension plans just look at your highest five-year average to determine your benefit, which accomplishes a sorta’ analogous inflation-based increase.
• If your pension plan offers an actuarial increase for delaying retirement, like the Social Security system does, you might benefit from that.

Ernie’s employer does not provide a traditional pension, so this does not affect him. But maybe yours does.

Ernie’s Additional Year of Savings. Back to the question of how much Ernie should save out of his extra year of work. We figured his projected retirement spending shortfall to be $17,270. Additional investment earnings, employer contribution and Social Security benefit will make up for $3,274 of that, leaving him with a remaining shortfall of $13,996. Since he uses the 4% Plan, he will need to save an additional $349,900 (=$13,996 / 4%). Which is 3-1/2 times his salary! Ain’t gonna’ happen. Instead, to treat the coming year’s Ernie the same as Future Ernies, he can reduce his annual retirement spending goal by $13,105, save $21,531 out of his final year’s salary (instead of the $8,426 he was used to saving). This will further reduce his spending deficit by $861 (4% x $21,531), from $13,996 to $13,105. He’ll have to live on $13,105 less this year and in the future.

Years of Additional Work. Can Ernie find enough fat in his budget to reduce his anticipated annual spending by $13.105? If not, maybe he’d better plan on working a few years instead of one. How many? Well, if his extra year of work got him $4,135 closer to his spending goal, a total of about four is projected to make up the whole $17,270. (The arithmetic is really pretty complicated, but four years is about right.)

So that’s Ernie’s choice: Work four more years or reduce his lifestyle by $17,270. Or something in between. What would—or will—you do?

I’m sure I haven’t thought of everything. If you have identified other factors of how delaying retirement affects your projected retirement spending, please post a comment or send me an email.