You may not be as ready for retirement as you thought you were. A new book by Wharton finance professor Richard Marston, Investing for a Lifetime: Managing Wealth for the “New Normal,” dispels some common beliefs about what Americans need to save for retirement. Recent reports have indicated that Americans should save eight times their income for retirement; Marston argues you should be saving closer to 15 times your income if you want to maintain your current standard of living.
In a recent interview with Knowledge at Wharton, Marston shares advice from his book on how to reach that goal by saving and investing.
An edited transcript of that conversation follows.
Knowledge at Wharton: Investing for a Lifetime: Managing Wealth for the “New Normal” has made a bit of a splash. It received a really good review in The New York Times. The book is about retirement, a subset of personal investing. One would have thought there wasn’t that much new under the sun in personal investing, but you come along and show that’s not the case. Let’s just start with the title where you talk about the “new normal.” What do you mean by that?
Richard Marston: It is bad enough if we’re in the “old normal” of normal returns that we’ve seen over the last 60 or 90 years. But [William H.] Gross [founder, managing director and CIO of] PIMCO came up with this idea of the new normal. In a sense, it’s pretty scary because he’s saying that because the industrial countries have slowed in growth, we’re not going to earn the same returns on equity that we have in the past. That means it is going to be harder to save enough for retirement. Once we’re in retirement, we might not be able to spend as much as we have in the past. So it’s a little scary.
Knowledge at Wharton: Everyone is aware that returns are down, and people complain all the time about how low interest rates are if you put your money in the bank and so forth. But there’s a school of thought that says, well, inflation is also slow. So isn’t it, relatively speaking, the same arrangement that used to be the case?
Marston: Bill Gross actually talked about equity — stocks, rather than bonds. But in my book, I talk about the possibility of a new normal for bonds as well. The reason for that is pretty obvious to most observers. We’ve been through a wonderful bull market for bonds where interest rates have come down for the last 30 years. Now we’re at the end. We don’t know whether the absolute end is going to be now or six months from now, or 15 months from now. But we do know that we’re near the bottom of the interest rates cycle, and inevitably, the interest rates are so low they have to go up.
The 10-year yield is at 2.5%. The inflation rate has recently been at 2% or close to 2%. That means we are earning virtually nothing on our bonds. That’s not going to go on. There has to be some increase in interest rates over the next five years. That’s going to hurt our returns because as interest rates rise, bond prices fall and we don’t get the returns that we had in the past.
Knowledge at Wharton: Maybe the key point in the book is that not only aren’t people saving enough — there has been talk of that before — but that they don’t even realize how far away they are from saving enough.
Marston: That’s right, the saving goal. When I talk about the savings goal in the book, the discussion of savings is really aimed at people in their 20s, 30s and 40s, rather than people who are near retirement. You have to think about the goal that you need for retirement. The way to think about retirement is, when I retire I want to have the same standard of living that I’ve had during my working years. How do you achieve it?
“A few years ago, one of the mutual fund companies said, there’s a rule of thumb: You need to save eight times your income…. You actually have to save close to 15 times your income.”
A few years ago, one of the mutual fund companies said, there’s a rule of thumb: You need to save eight times your income. When I read the report I was a little surprised because it seemed too low. That means that if you’re used to earning $100,000 a year, you have to save $800,000 to retire. That seemed to low to me. I formulated a section of the book on savings goals and how much you have to save. The long and short of it is, it is a lot more than eight times your income if you have normal income. If you have high income, because Social Security becomes less important as your income goes from $100,000 to $200,000 to $300,000, you have to save even more. For somebody who has worked all his or her life, is single and retires, and is used to earning around $100,000 a year, you actually have to save close to 15 times your income.
Knowledge at Wharton: Does that number take into account that some folks will have other income streams — Social Security, of course, comes to mind for most — that could lower that a little bit?
Marston: It does not take into account other income. If you’re lucky enough to have one of those old-style pensions, then you won’t have to save as much. But the majority of Americans in the private sector now only have 401(k)s and other pensions where they save the money themselves. For those people, that calculation takes into account Social Security. But I’m assuming that the family doesn’t have other pensions available. That’s the reality for an awful lot of people in the private sector.
Knowledge at Wharton: So, earning $100,000, you need to save roughly 15 times that income and have that in savings when you retire, if you want to maintain that level of income, even if you have $25,000, or something like that, coming in through Social Security?
Marston: That’s right…. It turns out that if somebody has earned about $100,000 a year and retires in 2013, they actually start off with about a $26,000 Social Security payment [at the maximum]. Now I should mention that if you’re married, and there’s a significant spousal benefit, the Social Security payment could go up and your savings goal could go down. But even for a married couple getting the maximum Social Security payment, who have earned $100,000 in their peak years, you actually have to save more than 11-and-a-half times your income in order to retire and have the same standard of living you had during your working years.
Knowledge at Wharton: That’s a best-case scenario, right there.
Marston: That’s a best-case scenario. But if you’re used to a higher level of income, you have to save more. So it makes it even more difficult.
Knowledge at Wharton: You talk about savings goals. What is the best way to set these goals? How do people do this? They have education for children to save for, and they have lots of other expenses. How do you accomplish that? What percentage of your income should you be saving to reach those multiples?
“Investing is easy because … all you need to do is to choose an appropriate portfolio, and there are lots of financial advisors who can help you with that. Then you have to have the good sense to leave it alone.”
Marston: Generally speaking, if you’re in the $100,000 range in income, you have to save something like 15% of your income, and that’s before any taxes. How do you possibly do that? The easiest way you can get a lot of the way to that goal is to fully participate in your 401(k) program at work. The defined contribution plans in America that have developed over the last 30 or 40 years are a tremendous boon to savings. What employees should be doing is joining as soon as possible and contributing as much as possible. At the very least, you have to contribute enough to get your full company match….
Then, if possible, save up to the maximum. In some cases, it is 15%. It’s an even higher number for people in their 50s and so on. Take advantage of that program. It makes such a difference because it’s automatic. Otherwise, a lot of Americans treat the savings as a residual. What they do is they do their mandatory spending, for example, on mortgages. Then they do the discretionary spending. Whatever is left over is savings. It’s much more difficult to do savings [in that way]. It’s much easier to do it automatically within a 401(k) plan.
Knowledge at Wharton: Attitudes about housing have changed a lot, too. The conventional wisdom used to be to buy as much as you can because it is an investment. Now, after house prices have fallen, people are no longer so sanguine about the housing market. But does that mean you are really better off buying a house that is less than you might be able to afford and putting that other money into savings, rather than thinking of the house as a savings vehicle?
Marston: You’re right, but I can even show that. I have a chapter on this…. It’s true even in California, where there are glorious rising housing prices. If you sold your house in 2006, having held it since the late 1970s, you would have been better off buying half the house and putting [the balance] it in a portfolio. You would have earned a higher return. Housing is a terrible investment in the long run for Americans. You should not buy more house than you really need for your comfort and your enjoyment.
Knowledge at Wharton: You mentioned another concept about the rate of savings. Tell us about that.
Marston: I figured that 15% — for someone of ordinary income [and] if you start saving early enough — will be sufficient to generate enough savings by the time you retire. It is important to mention that it makes a tremendous difference whether you start saving in your 20s or your 30s. In fact, I compare the situation for somebody starting at 26 as opposed to 36. To be honest, there are many Americans who can’t start saving in their 20s for retirement because they have university loans. They have the need to build up sufficient funds to be able to afford a mortgage, to buy into housing and so on. So there are a lot of goals for savings, particularly for people who are younger. But nonetheless, it’s so important to try to start saving earlier on.
You said at the outset that this book is about retirement. But really one third of it is about the saving that has to be done by younger people. The middle third is about investing wisely, and it’s nothing complicated. I try to make investing as simple as possible. The last third is about retirement. But what I say in the book is, investing is easy. What is difficult is the savings and knowing when to retire and knowing how to actually spend in retirement. Those are the tough things.
“The easiest way you can get a lot of the way to [your retirement] goal is to fully participate in your 401(k) program at work…. At the very least, you have to contribute enough to get your full company match….”
Knowledge at Wharton: Why is investing easy?
Marston: Investing is easy because, as far as I’m concerned, all you need to do is to choose an appropriate portfolio, and there are lots of financial advisors who can help you with that. Then you have to have the good sense to leave it alone. That means you’re choosing a portfolio in your 30s that is relatively aggressive to try to pick up the gains from equity, the gains from real estate and so on. Then, as you get older and closer to retirement, you reduce your risk. This is relatively straightforward. In fact, some mutual fund companies actually give you what are called target date retirement funds where you decide when you think you’ll be retiring. Let’s say you’re 35, and you think you’ll retire in 30 years. You buy a fund that’s appropriate for that. Then you just leave it alone. Before you know it, you’re ready for retirement, and you’ve done sensible investing. That is the easy part.
But there’s one caveat. If you start to play games with that portfolio, you can run into serious problems. I particularly mention this because we just went through a financial crisis where Americans were frightened. Stocks went down by more than 50%. Some Americans panicked, and they pulled out of the market, planning to get back into the market as soon as things look better. Well, now we’re five years into a rally, and an awful lot of Americans never got back into the market. Don’t play games with it. In the book, I do a calculation: I ask the question, suppose that you were unlucky enough to have retired in October 2007 at the peak of the market? The market was peaking, and let’s say you have saved $1 million. I ask the question, what would have happened if you just stuck with your portfolio?
Through the worst financial crisis since the 1930s, that portfolio fell very sharply during the crisis. But if you had left it alone, by the end of 2013, you would have been intact with almost exactly the same amount you started with. On the other hand… suppose you had pulled out in the spring of 2009. That $1 million dollars today would be scarcely more than $600,000 because you shifted out of your portfolio and tried to beat the market.
If you’re in that situation, for the rest of your life, your retirement will be diminished by that amount, by more than 40%, because you tried to be smarter than the market. Just leave the portfolio alone. Choose a good one. Seek advice from financial advisors to help you with that, and just leave it alone. It’s easy.
Knowledge at Wharton: You talked about the age of retirement, and that idea of timing it correctly. Tell us a good way to approach that.
Marston: The general rule is that if you are able to stay working until your full retirement age — it’s currently 66 for people who are about to retire — [that is optimal]. If you retire at 62, your Social Security benefits are actually 25% lower. So that’s the first decision you have to make. You have to be careful about this because not all Americans can work past 62. Not all Americans have their jobs past 62. So it depends upon what industry you are in and what circumstances you have.
“There’s a double bonus if you wait an extra four years [to the full retirement age]: Social Security is higher, and your savings are definitely going to be significantly higher.”
But to the extent that you can possibly wait another four years, it makes tremendous difference in two ways. First of all, the Social Security payment is much higher. But also you have four more years of savings. Those are years when you can save a lot of money because, for most families, college educations are already paid for. You have a lot of discretionary income at that point relative to the past. You can save a lot. But in addition, the money that you already had by the time you were 62 can accumulate further before you retire. So there is a double bonus if you wait an extra four years: Social Security is higher, and your savings are definitely going to be significantly higher.
Knowledge at Wharton: Another question people sometimes have, especially people getting close to retirement now is, if I don’t retire at 66, then each year my Social Security payment will increase by a certain amount. It might be even 8%. That’s a heck of a return if you keep working. In the second year after 66 it would go up, I believe, another 8%. So that’s a decision for people, depending on their health. There are many factors that obviously go into that. But what can you tell us about that?
Marston: There is a tremendous bonus if you are able to work until 70. As you say, you get a bump up by about 8% per year.
Knowledge at Wharton: I don’t think you have to wait until you are 70 to get each of those increments.
Marston: That’s right. Every year it is an extra 8%. Think of what the Social Security is. It’s an annuity payment, which is guaranteed by the government. It’s indexed to inflation. So it’s almost too good to be true. If you’re able to wait those extra years, you can have an enhanced payment for the rest of your life that keeps pace with inflation. It’s a wonderful program. A lot of Americans think that it’s not that important to retirement. When you do the numbers, for somebody earning as much as $100,000, or even $200,000, Social Security is a significant contribution to retirement, and it’s indexed to inflation.
Knowledge at Wharton: One last question, something I’ve always wondered about. You advise people to start saving as young as they can, in their 20s. At your first job out of college, open that 401(k), start putting something in. When I’ve looked at the charts, something really interesting happens when you start really young. Through the miracle of compound interest, you watch your money multiply. Of course, you are adding, but nevertheless you are gaining interest or dividends or whatever it may be. But then somewhere along the way … the line, which is sort of a slope, suddenly shoots into the stratosphere. What happens?
Marston: That’s the magic of compounding…. It’s amazing. I do that experiment in the book. I ask, what if you start at 26 or 31 or 36? It makes a tremendous difference. Even if you don’t contribute the maximum in your 20s, you are making progress toward that goal. Remember that that money is going to be compounding for 40 years rather than 30 years. So it makes a tremendous difference.
For those in their 20s, if you can start doing the contributions, that will make a difference later on. Boy, we have a long time to save, but later on, there are other obligations. There are children. There is education. There is paying the mortgage and so on. Try to start early, as early as possible. It makes a difference.