Retiring on Your Own Terms: Only by saving safely enough to end up with 22 times your annual retirement income can you guarantee that payout

Jan 31, 2014

THE INTELLIGENT INVESTOR

Retiring on Your Own Terms

JASON ZWEIG

By creating a new savings plan this past week called the myRA, President Barack Obama refocused attention on the retirement crisis.

While the myRA is a small step in the right direction, particularly for lower-income Americans, tens of millions of people remain trillions of dollars short of the savings they will need to fund their retirement.

The solution is simple, but it isn’t easy. Americans need to save more—not just a little more, but vastly more, according to a new study by two leading investment analysts.

To be assured of having enough money to fund a comfortable retirement, you should save a total of 22 times the annual income you want to earn when you retire. That is higher than many previous estimates, but it offers near-certainty of hitting your target.

For instance, if you want $100,000 in annual income (not counting Social Security), then your magic number is $2.2 million in total retirement savings. You can hit that magic number if you are prudent and willing to save money like mad.

Think of yourself as the sponsor of a traditional “defined benefit” corporate pension plan that sets enough money aside to guarantee a steady monthly income to retired workers for the rest of their lives. Then recognize that the only beneficiary of that pension plan is you.

That is the framework proposed in a recent article in the Financial Analysts Journalby Stephen Sexauer, chief investment officer for U.S. multiasset management at AllianzALV.XE -1.94% Global Investors in New York, and Laurence Siegel, who heads the CFA Institute Research Foundation, a financial think tank in Charlottesville, Va. They call it “the personal pension plan.”

How would you manage such a plan to ensure that it never came up short?

You would consistently fund it with ample savings, invest patiently in low-risk assets and structure the payouts to provide steady income during a long retirement.

Some pension plans themselves have come up short, but only because they promised too much in benefits or set aside too little in assets, say Messrs. Sexauer and Siegel.

Individual investors, Mr. Siegel says, don’t face the same pressures to fudge the numbers.

Many people working today are likely to live to the age of 100 or 105, says Mr. Sexauer. So if you work for 40 years, from your mid-20s to around the age of 65, you ought to plan on accumulating enough savings to last for up to 40 years of retirement.

How do the researchers arrive at their magic number of 22? Let’s say you earn $150,000 a year and believe you can live well in retirement on two-thirds of that, or $100,000. (Estimates of the percentage of your working income that you will need to live in retirement vary widely from 50% to 100% or more, but many people find they can live on less than they thought—even after accounting for health-care costs.)

The magic number answers this question: For each dollar of annual income you want in retirement, how many dollars of assets will you need to save before you retire?

Ideally, you want to be certain — not just pretty sure—that your money won’t peter out before you do.

The closest thing to a riskless asset is Treasury inflation-protected securities, U.S. government bonds that promise to preserve your purchasing power. Conservatively assuming a rate of return of zero, a $2 million portfolio of TIPS will enable you to withdraw $100,000 a year for 20 years.

With the remaining $200,000 you have saved, Messrs. Sexauer and Siegel recommend buying a deferred life annuity up front. That type of insurance generates a constant payout before inflation that will cover your income needs if you live past age 85.

The two researchers base their estimate of the cost of this kind of annuity on price quotes from several insurance companies (Allianz, Mr. Sexauer’s employer, isn’t among them).

That is how saving $2.2 million before retirement will generate $100,000 in annual income with near-certainty.
Many people count on earning high investment returns to reach their retirement goals. If you invest in riskier assets, you might get a higher return, enabling you to save less.

But you also might get a lower return; that is what makes “risky” assets risky. In that case you would have to save even more to make up the gap.

Only by saving safely enough to end up with 22 times your annual retirement income can you guarantee that payout.

Both Mr. Sexauer and Mr. Siegel keep much of their retirement savings in TIPS to protect against the risk of coming up short. (A comparable method, from investment manager BlackRock, uses slightly different assumptions and comes up with somewhat lower multiples of income that you must save.)

“What you’re doing here,” Mr. Siegel says, “is saving and investing the same amount that a defined-benefit pension plan sponsor would to fully fund your pension.” If you do that, “you’ll end up with the same answer”—a retirement you don’t have to worry about.