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%

Length of Retirement and Safe Withdrawal Rates

Brad asked a question in the comments of my last blog entry:

Wade - thanks for this post. I know it's still a work in progress but it's the first chart I've seen that shows MSWR for a 15 year retirement. I'm a Financial Planner that focuses on retirement income planning for my clients. Most research (Bengen, Kitces, etc) shows 30 year SWR's. But I recently had a client in his late 70's come to me to discuss retirement income. Seems like a 4% SWR would be inappropriate for someone with what could be a less-than-30 year lifespan. Michael Kitces and I emailed about this and he mentioned that even he hadn't done (or seen) the research on 15 - 20 year SWR's. Which brings me to my point: as a client ages and their retirement timeline moves from 30 to 20 to 10 years, the SWR should (I think) be raised to counter the effect of a declining lifespan. I, for one, continue to focus on a 4.5% - 5% SWR (I use Bengen's research plus Cuts/Freezes/Raises advocated by Guyton & Klinger) even when a client is in his/her 70's/80's. But, that doesn't "seem" right. Anyhow, thanks for letting me spill my thoughts and thanks for your research on this subject.

It's an important question!

The Trinity study does show portfolio success rates for retirement durations between 15 and 30 years.  But let me offer two other looks at it.  The first figure here shows William Bengen's SAFEMAX (the worst-case sustainable withdrawal rate from history since 1926 for a 60/40 portfolio of large-cap stocks and intermediate term government bonds) for retirement durations up to 40 years.  Indeed, shorter retirement durations allow for higher safe withdrawal rates.  For instance, for a 10-year duration, the lowest ever sustainable withdrawal rate in inflation-adjusted terms was 8%.

The next figure is based on Monte Carlo computer simulations of the same historical data as used in the previous figure.  It shows the "safe withdrawal rate" as defined by that which has a 10% chance of failure for different asset allocations and different retirement durations. Again, you can see that someone planning for either shorter or longer retirement durations should not necessarily be basing their decisions on the default 4% rule, as that comes from a 30-year retirement duration.