- The low yields we have now increase the amount necessary for a comfy retirement nest egg.
- $500,000 is only estimated to last for a 13 year retirement. Most retirees will completely miss the mark.
- Avoid risky assets no matter how tempting might the yield be.
Last week we discussed the true cost of low interest rates with particular attention paid to pension funding. Many defined pension plans are underfunded, and it’s a situation that has to be dealt with now despite it being against human nature to think about a problem that will only arise in the distant future.
On top of the problems in defined pension funds, low interest rates have a detrimental effect on general pensions and your retirement.
Many of us forget about the risks we take on when seeking any kind of yield, but those risks aren’t something to take for granted as they could leave you without a nest egg.
Today we’ll analyze the situation and discuss the options available for earning safely for your future retirement.
What Your Retirement Will Look Like
In the period from 1946 to 1964, 76 million people were born in the U.S. When we add immigration numbers to that, we can expect approximately 80 million retirees between 2014 and 2034, or about 4 million retirees per year.
All of these retirees were planning on retiring based on the assumption that stocks return about 10% annually, and treasuries a bit less. However, things have changed. Real returns for stocks have been averaging 6.8% since the 1870s, and treasuries have historically returned 2.7% but are even lower at the moment.
Figure 1: U.S. real returns by decade. Source: Business Insider.
As the bull market we’ve been in for the last 7 years has mostly been fueled by monetary easing, we can expect a decline in returns in the not so distant future.
Long-term stock returns are perfectly correlated to underlying earnings and the current situation isn’t that promising. With a PE ratio of 24.61 for the S&P 500, the returns we can expect from stocks is just above 4%, especially since the market PE ratio has mostly been below 24.6 with the historical average being 15.61. By dividing 100 with 15.61, we get 6.4% which is very close to what stocks have been returning historically.
Figure 2: S&P 500 PE ratio. Source: Multpl.
Of course, there are many other factors that can influence returns. One such factor is economic growth, but as we discussed yesterday, future economic prospects for developed countries looks bleak due to low inflation, lower productivity and an aging population.
The Average Retiree
The average retiree will live longer than retirees ever have before, and is mostly relying on do-it-yourself retirement planning. Traditional pension plans, which are underfunded, cover 30% of baby boomers, but only 11% of the adults born in the 1980s. This means that most retirees will have to rely on their own nest egg for retirement, which isn’t inspiring.
Let’s assume you have a nest egg of $500,000 when you reach age 65. If you have 50% in stocks and 50% in treasuries, your expected returns are 4% from stocks and 1% from treasuries at current rates which averages to about 2.5% for your complete portfolio. This would translate into a yearly income of $12,500 before taxes, which is far less than what the average American retiree spends ($43,600). In such a situation, you would run out of money in 13 years. You would need more than $2 million to retire comfortably with the current yields without eating up your nest egg.
Table 1: Retirement outlook with $500,000 nest egg. Source: Author’s Calculations.
The scary thing is that the median retirement account balance is just above $104,000 for people retiring in the next decade with a retirement account.
Figure 3: Retirement balance per age group. Source: UC Berkeley Labor Center.
For savvy younger investors, this should mean there is a need for increased savings and the hope that yields increase in the long term. On the other hand, higher yields would be very detrimental for those in or near retirement as it would lead to declines in values of both stocks and bonds.
What Can Be Done?
Well, the best option might be to save as much as you can and invest only when low risk assets give you a satisfying long term yield in order to prevent huge capital losses when yields go up. Limit your fees as those easily eat up your returns. You can limit your fees by owning really low cost funds (below 0.15% per year) or by investing directly into stocks and bonds through a discount broker.
Another thing to avoid in addition to high fees are risky assets that promise extraordinary yields in this environment. You can read more about that here.
Talking about retirement is very personal as many factors can influence your decisions. Some spend everything in order to put their kids through college, some put a new roof on the house while others save 25% of their net income and diligently invest in stocks through their entire working life. The most important thing is to know exactly what you want when you retire and adjust your behavior accordingly.
A good way to check if you are on track is to play with different investment yields and see where you end up. We have come up with a calculation by using Bankrate where an initial amount of $100,000, a monthly deposit of $500 and the current 4% yield from stocks result in a nest egg of $401,000 after 20 years.
Figure 4: Retirement targeting. Source: Bankrate.
$400,000 might not be enough to retire comfortably, but you can use the above program to check whether you are on track. If you are not, the best way to reach your target is to increase savings and not to increase your risks because a market decline could put you back many years.
Another solution to help you increase your retirement income, even on a severely underfunded retirement account, is to learn how to sell option premiums in a safe and conservative fashion. To learn more about our favorite option selling strategy, click here.