Directing the Surplus

The 1990's were an interesting time for American workers.  Public companies were making the transition away from traditional pensions in favor of defined benefit contribution plans.  The responsibility to save for retirement was now placed on the worker rather than on the employer.  Baby boomers were in their peak earning years and the stock market seemed destined to return 15% or more per year annually.  Financial firms were promoting the notion that not being invested in the stock market was a risky notion (never-mind the conflict of interest associated with this message, which will be the topic of a later post).  Because of the expectations of high returns built into the American psyche, workers assumed that they could invest a relatively small percentage of their wages into the stock market, wait for the market to do its magic, and then retire comfortably at age 65 without any change to their standard of living.  There were two very important questions that few seemed to ask:  1) Is this a reasonable and realistic at the individual level?  and 2) Is this workable and socially just for society as a whole?  This will be a two part post that will explore each of these questions separately.

Let's consider the question of whether or not saving a relatively small fraction of a person's income in the stock market over the span of a career and retiring comfortably on the proceeds first.  The thought exercise will produce some numbers that will be useful in the examination of the overall social impact of every employee following the same policy.

According to the Bureau of Labor Statistics, as of the 4th quarter 2011, the average worker aged 20-24 earns $467/week or $24,284 per year.  The average worker aged 55-64 earns $885/week or $46,020 per year.  Thus, over a 45 year working life a person can realistically expect their salary to double.  Side note:  this is a doubling in real, inflation adjusted terms.  To make the following thought exercise simple, all figures will be in real terms.  So, your "average Joe" can expect to start work earning $24,284 per year and expect a real salary increase of 1.4% per year.  The following graph illustrates "Joe's" salary over his working life.

Now Joe's employer, fully aware that the burden of preparing for retirement is now squarely on Joe's shoulders, offers Joe the use of a "magic piggy bank" on his first day of work.  The employer clearly spells out the features of the magic piggy bank for Joe as follows:

1. The piggy bank will accept up to 15% of the employee's salary
2. For every $1 the employee puts in this piggy bank, up to 5% of the employee's salary, the employer will match dollar for dollar.
3. The employer and the employer's financial advisers believe, but cannot guarantee, that the money in the piggy bank will increase by 7% per year, in real inflation adjusted terms.  Side note:  This is the market rate of return that was commonly accepted in the late 90's (and still accepted by many today).  It was an assumption promoted in Jeremy Siegel's book "Stocks for the Long Run".
4. There is also a possibility that the money in the piggy bank will only increase by 3.6% per year, in real inflation adjusted terms (of course, Joe had to read through the small print to even see that this was a possibility).  Side note:  The historical change in the price level of the US Stock Market from 1900-2010 was 1.6%, adjusted for inflation.  To this we add the current dividend yield of 2% to arrive at an expected 3.6% real rate of return from the market going forward.
5. At age 65 the employee can retire and start accessing this money; however, there will be a one time coin flip that will adjust the employee's total balance.  If heads comes up the balance will be adjusted upward by 20%.  If tails comes up the balance will be adjusted downward by 20%.

Joe, being atypical of the average American worker in that he doesn't mind doing a little math before committing his money, works out some scenarios to figure out if this is a good deal.  Ever the optimist, he focused on the most generous assumptions of a 7% rate of return with a 20% one time upward adjustment at the very end.  Joe assumed that he would work for 45 years, retire at age 65, live to age 85, and need $46,000 per year (his projected final salary) to enjoy retirement fully.  Quickly doing the math, he realized that twenty years in retirement multiplied by the funds he needed every year implied that he would need at least $920,000 in the piggy bank when he reached age 65.  It seemed like a large amount of money given his meager $24,000/year starting salary but after sitting through a few highly persuasive investing seminars he thought this goal might not be out of reach.

Armed with an Excel Worksheet he went to work projecting the growth of the money he planned to invest in the magic piggy bank.  After a few minutes he was very pleasantly surprised to find that saving only 5% of his salary will do the trick.  Below is one of the graphs he made to illustrate the "power of compounding" within the magic piggy bank.

In addition to a curve showing the projected balance in the piggy bank as a function of his age he also included a curve showing the total amount of fresh money he and his employer would contribute over the years.  Joe observed that if he contributed 5% of his salary to the piggy bank and was matched dollar for dollar by his employer that the total of contributions over 45 years would be a meager $152,000.  On the other hand, he predicted that by the time he retired the amount of money in the piggy bank would be nearly $1,000,000.  He will retire a millionaire!  All he would need to do is to save $76,000 of his own money, the employer would contribute $76,000, and the power of compounding would add $847,000!  Truly this WAS A MAGIC PIGGY BANK!!!  Saving for retirement should not be a problem at all!

Joe was so excited that when he went home this was the first thing that he showed his wife, Jane.  Jane, having been raised by a banker, was always a little wary when it came to finances.  She was always skeptical when something looked too good to be true.  To Joe's dismay, Jane immediately started questioning his assumptions.  "How can this possibly be true?  I recently read an article about this guy named Sated who was the leader of an island nation.  The story made a good point that working aged people would need to forego 25% of the fruits of their labor in order to sustain the inhabitants of the island.  Doesn't the same logic have to hold true for a country?  If everyone were to forego the consumption of only 5% of the fruits of their labor there wouldn't be enough surplus goods and services to satisfy the needs of the population as a whole."

"Oh honey", Joe said, "you would have to speak with the financial counselors who spoke to me to understand.  It has to do with the power of compounding.  If we get started right away then the money our savings generates will generate more and more money with each and every passing year.  Just take a look at the curves!  The math isn't hard to understand.  Here, take a look at the pamphlet the company gave me..."

Jane read through the pamphlet.  It was filled with many colorful pictures such as the curves the Joe showed her.  It also had numerous pictures of elderly people lounging on islands, golfing, water skiing, riding horses, etc.  They all appeared to be having a great time.  Every one of them had a big smile on their face.  Something didn't seem right.

"What's this footnote here about a possible 3.6% return and a potential 20% loss at the very end?", asked Jane.

"Oh, that's just a disclaimer.  The financial adviser told us that this possibility was so remote that it wasn't worth considering.", said Joe.

"Could you please humor me and put these numbers in your spreadsheet and see what happens?  How much money could we end up with if we only save 5%?", asked Jane.

Joe hesitated for a moment, but seeing how uncomfortable his wife was he agreed to do the calculations.  What he found was a little disturbing.  Below is a copy of his revised graph.

He brought the chart to Jane.  After a moment Jane said, "That makes more sense to me.  I've seen this work at my father's bank.  Combined, you and your employer are contributing $152,000.  Others who need this money will use it and return it to you with interest.  In the end, you'll have $271,000, which is $119,000 more than you put in.  Still, if you plan to be retired for 20 years and had to make this money last we'll only be able to afford to spend $13,500 per year.  This is only 30% of what you said we will need to have a happy retirement.  What would we need to do in order to meet the goal?"

Joe went back to his home office to start seeing what would happen if they saved a greater percentage of his income.  He started by increasing the percentage to 6%.  That didn't seem to have much of an effect, probably because the employer match had already been exhausted.  He increased it to 7%, then 8%, then 9%.  None of these savings rates got him close to the $920,000 end balance he felt they would need.  Finally he changed his savings assumption to 15%, the maximum amount his employer would allow him to contribute to the magic piggy bank.  The graph he brought to Jane is shown below.

"Jane, we have a problem.  Even if we save 15% of my pay we'll still fall short of the goal.  We'll only be able to count on having $542,000 when I retire.  I'm a little depressed now, but we need to discuss what to do about this."

"Well, look on the bright side", said Jane.  "If we hadn't discussed this we could have spent the next 30 years saving only 5% of your income.  If that had happened we wouldn't have any options.  We could have found ourselves in a situation where you were within 15 years of retirement with only $150,000 in the magic piggy bank.  That would have been a disaster.  At least being aware of this early enough gives us some options."

"And those are?", asked Joe.

"We can always save more.  The magic piggy bank only allows you to save 15% of your salary, but there are other places we can put our money, provided we're willing to sacrifice more now in return for some security later.  There are some other options as well.  For example, you can plan to work longer.  Working an extra few years gives you more opportunity to save, and the final balance will not need to last for as many years.  We can also plan to downsize in retirement.  If we can find a way to be content with less when we retire then maybe we won't have to sacrifice as much in the near term future."

"I don't like any of those options", said Joe.

"Of course not honey.  That's why that brochure they gave you at work is so inviting at first glance.  It wouldn't have been nearly as compelling if they provided you a glimpse of reality.  Let's discuss why that 7% real rate of return is just not reasonable..."

(to be continued in part II)