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.

Truing Up Your Savings Goal

Let’s say you’ve been a good boy or girl, and you’ve gone through a sensible process of figuring out how much you should save out of your current salary. Just like the example of Ernie from Thursday's post. And, like Ernie, after your first pass you find you’re saving too little or too much. You’re cheating Future You to benefit Present You (saving too little); or you’re cheating Present You to benefit Future You (spending too little). What do you do next? Well that depends. It depends on which of the following five categories you find yourself in. I’ll list them from luckiest to unluckiest.

Wealthy. You find you’re saving more than enough to keep the Future You living the lifestyle of the Present You, and you have no desire to increase your standard of living. You would get no real pleasure out of doing so. Congratulations, either you’re wealthy, or you’re on your way to wealthy! Start working on your estate plan.

Matched. The amount you need to save to provide for the Future You is actually less than the maximum amount your employer matches in its 401(k) plan; but you could make good use of an increase in spending nonetheless. Maybe you would change your razor blades more frequently. Or start buying the frozen vegetables with the sauces built right in. Whatever. Now you’ve got a tough choice. Do you plump up Future You at the expense of Present You, just to get that employer match, 25%, 50%, whatever it is? My own opinion is that you do. It’s generally smart to go for that instant return on investment. There are so many uncertainties in life anyway, you are bound to encounter future events that cause a drop in Future You’s lifestyle. Why not just get a jump on your saving on your employer's nickel.

The Middle. The amount you’re saving toward, your savings target, is based on your current spending rather than trying to avoid dropping below your personal poverty level. (Remember the Two Multipliers?) Then you should increase (if you’re saving too little), or decrease (if you’re saving too much) your annual saving. By how much? You’ll have to do some fancy arithmetic to figure that out, since your current spending level is determined in part by how much you’re saving. But that mare’s nest is a subject for another post.

Personal Poverty Level. Your savings target is based on keeping the Future You from dropping below your personal poverty level. This describes the situation in which Ernie finds himself in the example from Thursday's post. Then you should just increase or decrease your annual saving to the amount determined on your first pass. Saving more will be hard, but at least the arithmetic is easy.

Under Your Poverty Line. Your savings target is based on keeping the Future You from dropping below your personal poverty level, but if you increase your annual savings to avoid that, then the Present You would drop below your personal poverty level. You’re screwed! It’s time to rethink your standard of living or how you define poverty.

Your Employer’s Contribution

Yesterday’s post illustrated the example of someone in his working years saving toward a retirement goal. But maybe there’s a third leg to your two-legged stool. Maybe your employer is helping with your retirement saving by contributing to your retirement plan. They might not be helping you with any of the decision-making (how much to save, how to invest it), but at least they might be helping with some of the dollars.

In yesterday’s example, Ernie figured he needed to save $11,426 of his $100,000 annual salary. Let’s add another fact: Ernie’s employer sponsors a 401(k) plan, and has consistently made annual contributions to it. In fact, his employer has said that it will match 50 cents on the dollar of its employees’ contributions, up to a maximum employee contribution of 6% of salary. Employees may contribute more, but only the first 6% of salary will get matched.

So Ernie figures he’ll contribute at least $6,000 (= 6% x $100,000) and his employer will contribute $3,000 (= 50% x 6% x $100,000). Ernie’s savings burden is reduced to $8,426 (= $11,426 - $3,000). Alright! That’s only 8.4% of his salary, an acceptable burden.

In this example, Ernie’s employer historically matched 50% of the first 6% employee deferral. That’s a typical employer matching scheme, but by no means the only one. Your employer’s match may be 25 cents on the dollar, or may be capped at 8% of your salary. Or maybe your employer doesn’t provide a matching contribution, but has historically made contributions for all employees, varying with its annual profits. Or maybe your employer doesn’t provide any contributions whatsoever (the cheapskates!). Or maybe they have provided matching contributions in the past, but this year announced a temporary suspension in light of the crummy economy.

All of that variability leaves you with the burden of projecting (not predicting, projecting) how much your employer will contribute in the future. If you take the conservative approach, and project no help from your employer, then the Present You will have to save more and spend less. And if your employer then in fact makes contributions, the Future You will be able to reduce his contributions and increase his spending. Or, conversely, if you assume your employer will continue to contribute, but it does not, the Future You will have to increase his rate of contributions and take a cut in take-home. I say go with the odds and make your savings decision based on your assessment of the most likely scenario.

So now Ernie thinks he has his annual savings goal—$8,426 per year. Not so fast, Grasshopper. If you will remember back to last Friday’s post when we invented Ernie, one of the givens we started with was that Ernie was saving $6,000 per year. Now he figures it should $8,426 per year. Which is it? Maybe neither. But that’s a subject for a later post.

Your Annual Savings Goal

In yesterday’s post, I kind of left my friend Ernie hanging because I had to go. I was using Ernie as an example to illustrate how someone in his working years might turn a retirement target into a savings goal. It’s time to take another step.

A recap. Ernie, who earns $100,000, has established a future retirement savings target of $948,750, of which $321,890 is expected to be taken care of by his prior savings. That leaves him $626,860 to save out of his salary. Ernie wants to be equally fair to Present Ernie and all Future Ernies, so he plans to spread that burden over his 25 remaining future years of work.

He could just divide the $626,860 by his 25 remaining years, but that would be, in effect, assuming that his savings do none of the work for him. That’s not realistic. As bad as we all feel about last year’s (and yesterday's) financial markets, it’s not reasonable to assume that will continue indefinitely. I hope. Instead, Ernie recalls yesterday’s reasonable assumption that over the long run, his assets will earn about 6% per year. That’s not a prediction; it’s just a projection.

Ernie projects he will need to save $11,426 per year for the next 25 years, which is 11.4% of his salary. How did he do that? Here are a couple of ways.
• You can use a financial calculator.
• You can use the following formula, where “F” is the future value of the amount you need to save ($626,860); “r” is the assumed rate of return (6%); “N” is the number of years of saving (25); and “Pmt” is the amount of annual saving you’re trying to determine.

Pmt = F * [r/([1 + r]^N – 1)

• You can use an Excel spreadsheet.

Are you doing all your retirement savings on your own, or is your employer contributing something? If your employer historically has made a contribution to your retirement plan, it might be reasonable (there’s that word again!) to project that it will continue to do so. That requires another step. But that’s too much for one day. To be continued.

The Fruits of Your Assets

A few posts ago, I discussed the establishment of a savings target. So how do you turn that target into a savings goal for the year? I’m glad you asked.

Remember the example of Ernie? He had established a target. He wants to have $948,750 saved by his retirement. Let’s add two facts: Ernie is 25 years away from retirement, and has already accumulated $75,000 in a 401(k) account. Good for him! Because that $75,000 will do part of the work for him, reducing the burden on Present Ernie and Future Ernie. Thank you, Past Ernie.

Ernie wants to do a projection of how much of his $948,750 target he can expect his $75,000 to cover. First he needs an assumption about what rate of return he might expect. There’s no way to know that, but it’s not so important that his assumption be right. It won’t be. Not even Ernie can predict the future. Rather, it’s only important that it be reasonable. He can (and should and, by golly, will) make mid-course corrections every year to make up for his inevitable failure to predict the future. So what’s a reasonable assumption? For illustration purposes I will use 6%. In a future post I will describe the myriad factors that go into that assumption, but for now, grant me that it’s reasonable.

Ernie projects that, in 25 years, with an investment return of 6%, his $75,000 will be worth $321,890. How did he do that? There are lots of ways to do that sort of financial projection.
• You can use a financial calculator.
• You can use this formula, where “A” is your current assets ($75,000); “r” is the assumed rate of return (6%); “N” is the number of years to go (25); and “F” is the future value of your assets:

F = A * (1 + r)^N

• You can use an Excel spreadsheet.

Lots of ways to get there. The important thing is that Ernie’s prior savings are going to do 34% of the work for him, leaving him with a net target of only $626,860 to save for out of his current and future salary. So how much should he save? That’s for another post, because I gotta go.

A Tale of Two Multipliers

In a comment to Wednesday’s post, Anonymous made a very good point. He or she said that it’s hard to adjust your standard of living. Indeed it is. Very hard. Which is what people like about a spending plan that will very likely not require them to have to do so.

Which is why it is a good idea to have a sense of where your personal poverty level lies (as recommended in yesterday’s post). Because it’s your personal poverty level that pretty much defines the spending you can’t realistically drop below. Think of it as the level at which you join the Nation of Whiners. Above that level, and you could adjust, as unpleasant as that might be. So when you’re working, and trying to determine a retirement savings target, you should actually have two targets in mind. One is based on the Present You’s current spending level, and one is based on your rough estimate of your personal poverty level. You can afford to use a realistic approach toward saving up the first target. But you should be very cautious—even pessimistic—about saving up the second target.

Here’s an example. Remember Ernie from Friday’s post. He had figured that he needed his future retirement savings to provide him with an income of $47,950. Adding projected Social Security would give him a retirement income of $65,950, which is comparable to his current lifestyle (which you may recall was $86,350, before adjustments). To translate that $47,950 into a savings target, he multiplied it by a reasonable multiplier, one that is likely to give him a sufficient war chest; he chose 17. His tentative target was $815,150 (= 2517 x $47,950).

But Ernie really needs to take a second step. He can afford to be reasonable about saving for his current standard of living, but he has to be unreasonably conservative about saving for his personal poverty level. He simply couldn’t stand entering the Nation of Whiners, and he’s willing to take any reasonable steps to avoid going there. So Ernie searches his soul. He asks himself how low his spending can drop below $86,350 without being too painful. After some thought, Ernie figures he could adjust his spending by $10,000, down to $76,350. That would mean, after Social Security and other adjustments, his retirement savings would have to provide him with $37,950 (= $47,950 - $10,000) to support his bottom line lifestyle. So he has to be unreasonably cautious about saving up that amount.

How do your translate that caution into a savings target? By using an unrealistically conservative multiplier; 25 instead of 17. So his alternative target is $948,750 (= $37,950 x 25). He has to save up the greater of the two target amounts, $815,150 or $948,750. Bummer.

It’s worthwhile to remember what these two different multipliers represent. The cavalier multiplier (17) gets you to a retirement level that is likely to be similar to your current lifestyle, but which may require the Future You to be flexible about making those difficult spending adjustment if things don’t go as expected. The conservative multiplier (25) gets you to a retirement level that is damn likely to never drop below your personal poverty level.

There are a lot of implied decisions behind these two multipliers, and your multipliers may well be different. But that’s a subject for another day.

Your Savings Target

When it comes to saving for retirement during your working years, you need a target—some amount that when you’ve saved it up, you can feel confident in giving up your source of income if that’s what you want to do. How much is enough? Unfortunately, unless you put some thought into this question, the answer will be there’s never enough; you’re doomed to be a wage slave for the rest of your life. To be freed from the bonds of financial slavery, you should have a numerical target in mind.

Coming up with your target is a complicated process, but you can start with a tentative step, and build and hone from there. So here it is, your first step: Start by determining your current annual allowance—now, during your working years. Then make a few adjustments. And then multiply it by a suitable multiplier. And that’s your target. What could be simpler?

First, your allowance. Remember the goal of retirement planning, the principle that you want Future You to live just as comfortably as Present You, no more no less. Your current salary that you live on is a pretty good starting point. It sort of defines your standard of living. An example is helpful. Consider Ernie, who earns $100,000 salary. Present Ernie wants to plan for Future Ernie to live the $100,000 life.

Next some adjustments. Ernie does not live on the full $100,000. There’s two common adjustments that disappear when he retires. The first is Social Security and Medicare tax, which he never gets to spend. And which he will cease paying when he retires. So Ernie can reduce his tentative $100,000 spending goal by 7.65% (the combined FICA tax rate) down to $92,350. The second is retirement saving. Let’s say Ernie contributes 6% of his salary ($6,000) to his employer’s 401(k) plan. So he’s not living on $92,350; he’s living on $86,350. His target is shrinking. It’s looking more attainable.

Then there are some common expense adjustments. Now Ernie pays his mortgage every month. That’s a big component of his living expenses. Ernie checks his statement and realizes his mortgage will have been paid off before his projected retirement date. That’s an expense that will disappear—$24,000 per year in Ernie’s case. (Just the principal and interest; not the escrow for taxes and insurance, which goes on forever.) Ernie’s commuting expenses are another adjustment; in his case $2,400 per year. But expense adjustments can go both ways. Ernie’s employer now pays for his health insurance. While he anticipates Medicare eligibility at age 65, he also anticipates a cost of supplemental insurance at $6,000 per year. After taking these adjustments into account, Ernie’s target has shrunk to $65,950.

But wait! There’s more! Ernie has been paying into the Social Security system which will provide up some of that $65,950. He goes to the Social Security website, and uses the wonderful calculators there to project his annual Social Security benefit, which he finds will be $18,000. If his employer had sponsored a traditional pension plan, he would further adjust for his projected pension benefit, but alas that is not the case. Nonetheless, Ernie’s target has shrunk to $47,950 per year.

Final step, Ernie multiplies that by a suitable multiplier. How much of a multiplier? Is it 25? Or 20? Or 17? That depends on the spending and investment plan he intends to adopt when he gets to his intended retirement age. But that’s a subject for another post. For the sake of discussion, let’s say his multiplier is 17. Then his savings target becomes $815,150.

Now Ernie has a concrete goal. He has a plan! Ernie is very happy.