Thursday, November 17, 2011

Future Salary Assumptions for my Research

I received this question:

I did have a question about income replacement rates.  In some of your articles you refer to a person replacing 50% of their income (with SS added on top).  Is that 50% of their final salary?  How would you estimate that if a person still has 15+ years more till their expected retirement?  Is it save until I can have enough to replace 50% of my current income, or do you just inflate earnings by like 3% a year?

This refers in particular to my "Safe Savings Rates" and "Getting on Track for a Sustainable Retirement" articles.
Both of those articles are meant to illustrate a framework.  I still need to develop some interactive software that will allow users to incorporate their own assumptions.

I provide calculations in real terms, which means adjusted for inflation.  And I assume that someone has a constant real salary over their whole career. Their salary rises with inflation, but there is no change in real terms.  This means that talking about replacement rates in terms of final salary is the same as replacement rates in terms of current salary, in real inflation-adjusted terms. That simplifies the discussion dramatically as I don't need to jump around to talk differently about different points in one's career.

Obviously, this is not realistic.  Real people do not have such constant real salaries. It is a limitation of the research.  But since everyone will have a different personal case, I thought this was okay as a baseline to explain the approach.  

Let me give a bit more insight about the 16.6% savings rate from my "safe savings rates" article.

If everything about the baseline case is the same, except that the worker enjoys 1% real wage growth every year for their 30-year long career, then the safe savings rate increases from 16.62% to 19.81%. Two factors are at work:

1. Relatively less salary and savings are made early in the career, so less time for compounding

2. Now the real wage at retirement is 33.45% higher than in the first year of work. Since the worker wants to replace 50% of this final wage, she needs to have saved more.

Next, interestingly, if you combine the 1% real wage growth with the scaled age-earnings profile for workers aged 35-64 taken from Social Security Administration data, the safe savings rate falls to 13.47%. People who are still working at age 64, tend on average to have lower real wages than younger workers. Real earnings tend to peak at about age 50 and then decline at later ages for the average American (this is real earnings, not nominal earnings that incorporate the effects of inflation). I am assuming that you want to replace your final salary. If you want to replace your peak salary, it is another story, but since your final salary is now less in real terms than earlier in your career, then you did not need to save as much.

Now, everyone, again, is different.  And plenty of people will need to deal with mid-career unemployment and things of that nature, which will require higher savings rates in other years.  So, of these numbers, the 13.47% might actually be closer to most realistic, but if you want some precautions for unemployment or emergency expenses in some years, then that could get us back closer to 16.6%

4 comments:

  1. There is a spreadsheet that incorporates both wages rising with an inflation input and also with a 'real' increase as well. The % saved each year has a variable for a steady increase as well. The results show the resulting nominal portfolio relative to the ending nominal salary.
    http://www.retailinvestor.org/Howmuchsave.xls

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  2. Thanks RetailInvestor,

    While I think your spreadsheet can provide a good starting base for someone 30-40 years from retirement when it is more reasonable to assume a long-term return, by the time you are 5-10 years from retirement it is no longer helpful to assume compounding with a fixed return. Over these shorter periods, returns are quite volatile and far from the long-term average. This is exactly what I was critiquing in my "Getting on Track" article. Please see the section of it called:

    Charting Progress to a Wealth Target in a Sea of Volatility

    Thanks, Wade

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  3. Looking at it from your perspective I don't disagree. But the person close to retirement who plans to buy an annuity can use the spreadsheet to see exactly where he is and what return he has to realize in the interim (given the other variables). As you point out the large portfolio at this later date means any poor returns have a big impact, so the person may well chose to retreat to 'safe' investments for the interim.

    It is my opinion that annuities are too frequently ignored in the retirement issue.

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  4. Hi, Yes, your spreadsheet is quite helpful for one getting close enough to lock in their wealth target with fixed income, which they will then use to buy an annuity.

    However, how will the person know how much the annuity will cost in a few years?

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