With Retirement Savings, It’s a Sprint to the Finish

What would you do if your financial planner prescribed the following advice? Save and invest diligently for 30 years, then cross your fingers and pray your investments will double over the last decade before you retire. You might as well go to Las Vegas.

Yet that’s exactly what many professionals and fancy financial calculators have been telling consumers for years, argues Michael Kitces, director of research at the Pinnacle Advisory Group in Columbia, Md., who recently illustrated this notion in his blog, Nerd’s Eye View.

The advice is never delivered in those exact words, of course. Instead, this is the more familiar refrain: save a healthy slice of your salary from the start of your career, invest it in a diversified portfolio and then you should be able to retire with relative ease.

The problem is that even if you do everything right and save at a respectable rate, you’re still relying on the market to push you to the finish line in the last decade before retirement. Why? Reaching your goal is highly dependent on the power of compounding — or the snowball effect, where your pile of money grows at a faster clip as more interest (or investment growth) grows on top of more interest. In fact, you’re actually counting on your savings, in real dollars and cents, to double during that home stretch.

But if you’re dealt a bad set of returns during an extended period of time just before you retire or shortly thereafter, your plan could be thrown wildly off track. Many baby boomers know the feeling all too well, given the stock market’s weak showing during the last decade.

“The way the math really works out is unbelievably dependent on the final few years,” Mr. Kitces said. “I just don’t think we’ve really acknowledged just what a leap the very last part really is.”

Consider the numbers for a 26-year-old who earns $40,000 annually, with a long-term savings target of $1 million. To get there, she’s told to save 8 percent of her salary each year over her 40-year career. (We assumed an annual investment return of 7 percent, and 3 percent annual salary growth, to keep pace with inflation). Yet after 31 years of diligent savings, her portfolio is worth just slightly more than $483,000.

To clear the $1 million mark, her portfolio essentially must double in the nine years before she retires, and the market must cooperate (unless she finds a way to travel back in time and significantly increase her savings).

Should the markets misbehave, however, delivering a mere 2 percent return over the 10 years before retirement (not all that hard to imagine, considering the return of a portfolio split between stock and bonds over the last decade), she falls short by about a third. Her portfolio would be worth only about $640,000. The chart accompanying this column illustrates this.

You can quibble with our assumptions in this example. But a similar pattern emerges regardless of your financial targets and projected returns, Mr. Kitces says. So if your target is to save $500,000 or $2 million, and if you assume a 6 percent return or a higher 10 percent, you’re still relying on your investments to roughly double in the final years before retirement.

Of course, an extended period of dismal returns during any point in your career can inflict damage. But the homestretch before retirement is often the most anxiety-inducing because workers have neither the time nor the financial capacity to recover before they begin taking withdrawals. "Getting the bad 2 percent decade in the earlier years has far less impact because there are fewer contributions already invested,” Mr. Kitces said. “Conversely, when the bad returns come in the final 10 years, no reasonable amount of savings will make up the shortfall."

So what’s an investor to do about all of this, especially as one of the other pillars of retirement savings — pensions — disappears? And who’s to say how Social Security may change by the time that 26-year-old retires?

Most of the solutions, if you can call them that, fall into the “easier said than done” category. If you can’t handle the uncertainty of missing your financial targets, you can try to save more and create a less volatile portfolio, Mr. Kitces says, which may also provide a firmer retirement date.

And naturally, the earlier you start saving, the sooner you’re likely to reach the critical mass you’ll need for compounding to accelerate (assuming the markets provide some lift in the first half of your career). But you will still need to save more than many retirement calculators suggest, since they’re likely to recommend saving a lower amount when you have such a long time horizon. Then you can end up in the same predicament, where you are heavily leaning on market returns in the years before retirement.

“What the wise person does is save a large amount of money when they are young,” said William Bernstein, author of “The Investor’s Manifesto: Preparing for Prosperity, Armageddon and Everything in Between” and other investing books. “And if they can do that, when they are older, they can cut back on their equity allocation. When you’ve won the game, you stop playing the game.”

But that can be hard to accomplish when you have other needs competing for those dollars, whether it’s a down payment for a house, a 529 college savings plan or starting a business. Or perhaps you’re already living on less because you’re unemployed (or underemployed) or because health insurance consumes a significant chunk of your income.

“It’s the cruel irony of retirement planning that those people who most need the markets’ help have the least financial capacity to take the risk,” said Milo Benningfield, a financial planner in San Francisco. “Meanwhile, the people who can afford the risk are the ones who least need to take it.”

A more prudent course of action is a flexible one that acknowledges the many possibilities and accounts for ideal and less-than-ideal spending amounts.

Try using different assumptions for the years leading up to retirement, suggests Scott Hanson, a financial planner at Hanson McClain in Sacramento. If you want to retire in 25 years, for instance, you might use a return assumption of 8 percent for the first 15 years of savings, then reduce that rate to 6 percent or less in the final decade, he says.

“Here’s the catch: most folks aren’t saving enough using standard growth assumptions,” he said. “If they begin to use lower growth assumptions in order to ensure their retirement, they’ll fall further behind and become even more discouraged.”

But simply going through these exercises may help the reality sink in. At the very least, it will show how imprecise even the most sophisticated projections may be.

“The actual date I get to check out with my target sum to retirement is much more uncertain than we give it credit to be,” Mr. Kitces said. “It’s more like 40 years, plus or minus five to 10 years. If you want more certainty, you can have it, but you have to save more and take less risk.”