Finding balance while planning for the future, whether that be retirement or shorter term goals, is a conversation I frequently have with individuals of all ages. For mid-career professionals it often means striking a balance between living an exciting, purpose filled life while simultaneously taking necessary steps to prepare for life in retirement. For pre-retirees or retirees it often means creating a spending plan that allows them to use their life savings to live the retirement lifestyle they’ve always dreamed of. While balance is the common theme, the approach towards planning differs quite drastically. This blog is focused on those in the accumulation stage of their financial journey, and a unique approach to finding the balance that is vital to the success of any sound financial plan.
Balance and Planning for Retirement
Most of the initial conversations I have with individuals and families start along the lines of “we are starting to make some decent money and want to begin optimizing the decisions we are making around our short and mid term goals, as well saving for retirement”. To me, this is the essence of financial planning for early and mid career professionals. As humans we are wired to seek out short term gains, as evidenced by the recent meme stock craze or the increase in day trading during the pandemic. Nothing is more exhilarating than experiencing the dopamine rush that comes from the potential to make money in a few hours or days, or splurging on that new Tesla, outfit or new pair of running shoes (I swear they make me faster).
Those who succeed in putting together a sound financial plan are able to slow down and realize that most things worth having in life come from disciplined approaches that can take years or decades to materialize. What fun is that? As a financial planner I am constantly preaching about maintaining discipline while saving and am a strong proponent of investment strategies that avoid the new fad or next big thing because “this time it’s different!”. With that said, I find it negligent to deprive yourself of today’s experiences, whether that’s the month-long trip to Europe you’ve always dreamed of or taking that remote job that allows you the flexibility to experience things the 9-5 office job simply can’t match. Who knows what tomorrow will bring? In my opinion, it’s just as costly to forgo your dreams for today in hopes that they materialize 30 years down the road in retirement. There is a point where saving too much has an opportunity cost that extends far beyond the numbers on a spreadsheet.
A Research Based Approach to Retirement Planning
Academic studies around retirement planning have, for the most part, focused on retirement income planning and helping clients determine how much they can withdraw from their financial assets to meet spending needs when employment income stops. Retirement income planning seeks to strike a balance between a client’s tolerance and ability to take risk, as well as avoid the opportunity cost of spending too conservatively throughout retirement, so that their desired living standard isn’t achieved.
But what about retirement planning when it is 20 or 30 years away? How do we approach this with the same academic rigor that retirement income planning presents? The 4% “safe spending rate” is prevalent throughout the industry and public (despite the numerous recent studies questioning its validity in current market conditions, there are as many that defend it). Research has shown that withdrawing 4% from your initial portfolio annually, adjusted for inflation can help retirees avoid outliving their money. Multiple rolling thirty year retirement periods were included in the study, which concluded that there is a high probability you won’t outlive your assets if the rule is followed. The flip side of the 4% rule coin is the saving rate that will enhance the probability of us accumulators saving enough for retirement.
Safe Savings Rates and A Unique Approach to Retirement Savings
Determining your safe savings rate includes a multitude of factors, not the least of which is the relationship between stock market valuations and sustainable spending rates in your distant (or not so distant) retirement. When saving at your safe savings rate you can “expect to finance intended expenditures [in retirement] with as much confidence as we give the 4% rule” no matter your level of wealth, according to Wade Pfau. The proactiveness of this approach differs greatly from traditional retirement income planning, as you are taking control of your retirement today, rather than working with what you have in the future.
When coming up with your plan there are two high level steps that can get you started on your path:
- Estimate potential withdrawals needed from your financial assets (after accounting for Social Security, any defined benefit pensions you may have, or other income streams from real estate, etc. )
- Decide on a savings rate that you feel comfortable with, which can be determined by calculating what can sufficiently get you through your desired retirement spending. This should be based on historical data, as well as an understanding of current market conditions.
In layman’s terms the process can be defined as setting a wealth accumulation target (e.g. 50% replacement of current salary) to cover expenses in retirement and determining the annual savings rate, based on how you are invested, to meet that target.
The effectiveness of this strategy is found in its simplicity and the flexibility it allows regarding the other areas in your cash flow. If, for example, your analysis determines that a 17% savings rate will set you on your path to your wealth accumulation target, you will have the confidence to spend on the experiences and goals that matter most to you with the understanding that your future self will also be taken care of.
This approach and the research that accompanies it has shown that, independent of the market conditions in retirement, the savings rate method was successful in 87 different 30 year retirement periods from 1901 to 1987. Again, this is no guarantee! However, according to Pfau, retirement planning in this context is “less prone to making large sacrifices” often seen when following an overly conservative strategy.
Applying Research to Real Life
Similar to the research accompanying safe withdrawal rates, the safe savings rate relies on historical data, and there is no guarantee that the future will look like the past. Additionally, the savings rate analysis is heavily dependent on the assumptions used (performance, volatility, correlation) for different investment asset classes. However, it is a starting point and you can build in some conservatism through the assumptions used in calculating your savings rate. Rates can and will vary from family to family depending on anticipated spending needs and time to retirement.
While real life is almost always murkier than the figures provided in academic research, it is a starting point that allows you to create the balance that is so often sought after. Lives, income, spending levels and markets all fluctuate in real life. These can be positive or negative developments, and can be handled with a financial planning approach that emphasizes flexibility and adjustments. Regardless, creating a starting point that provides insight into how much you should theoretically be saving allows you to balance your retirement savings with all of the experiences that make life worth living. For me, this approach finds the balance between saving and experiences that is so commonly sought after.
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