Ready for today’s retirement financing pop quiz?
Which of the following has the biggest impact on your ability to sustain your preretirement standard of living?
- Better-than-average market returns
- Dipping into home equity to supplement traditional retirement financing (401(k)s, IRAs, pensions, and Social Security)
- Delaying retirement until age 70
Give up? The third answer is the correct one, according to new research from Vanguard. It’s not even close.
Don’t be too hard on yourself for thinking the correct answer is the first one, since almost everyone makes this same mistake. But better-than-average market returns make a surprisingly small difference, according to the Vanguard Retirement Readiness Model (VRRM), a new and proprietary model that Vanguard recently created. The VRRM calculates what Vanguard calls the “sustainable replacement rate,” which is “the percentage of preretirement income that a worker can replace throughout retirement in 90% of market and mortality scenarios.”
Consider a worker whose preretirement income is at the 50th percentile of the nationwide income distribution. Given how much this median worker has saved and invested for retirement, and assuming that stocks, bonds and inflation are as good or bad as in the past, and the worker relies on traditional sources of retirement financing (401(k)s, IRAs, pensions, and Social Security), his sustainable replacement rate (SRR) is 50%. In other words, in 90% of market return scenarios, this worker in his retirement years can safely count on being able to spend at least 50% of his preretirement income.
That’s far short of the 83% that Vanguard estimates this worker in retirement would need to maintain his preretirement standard of living. To explore what could improve this median worker’s chances of maintaining his preretirement standard of living, Vanguard measured the impact of changes in three areas. These are the three options listed in my pop quiz above.
Improved market returns. Vanguard arrived at a 50% SRR for the median worker by assuming Vanguard’s projected capital market returns in coming decades. To measure the impact of a more optimistic scenario, Vanguard assumed that future returns will be at the 75th percentile of professional forecasters projections. Believe it or not, that improved the SRR by just 1 percentage point. In contrast, the SRR fell by just 2 percentage points under a pessimistic scenario in which future returns are at the 25th percentile of forecasters projections. In other words, relative to a pessimistic scenario, an optimistic scenario for future market returns increases the SRR by just 3 percentage points.
Accessing home equity. Vanguard next estimated the impact of allowing the retiree to supplement his retirement income by accessing home equity, either via using a reverse mortgage or by selling and moving to a lower-cost housing market. This increased the SRR for the median worker by just 4 percentage points.
Working longer. Working longer potentially improves the SRR in four ways. It increases the number of years in which the worker is contributing to his retirement portfolio, it increases the number of years in which that portfolio can be earning a return, it reduces the number of years that funds need to be withdrawn from that portfolio, and it increases the monthly payout from Social Security. So it shouldn’t be a surprise that working longer makes a big difference to a median worker’s SRR. Working just one year longer increases the median worker’s SRR by 3 percentage points, according to Vanguard. And waiting five years to retire—to age 70 rather than the 65 assumed by the VRRM—increases it by significantly more than 15 percentage points.
Why does Vanguard’s “optimistic” market scenario make such a small difference to the median worker’s SRR? The answer is that the median worker has relatively little invested in his retirement portfolio to begin with, and has relatively little of that portfolio allocated to equities.
Better-than-average capital market returns have the biggest impact only for the highest-income workers, since they have the largest retirement portfolios and the most allocated to equities. But Vanguard projects that such workers in retirement will be more than able to sustain their preretirement standard of living, even without assuming the “optimistic” scenario for future capital market returns.
The bottom line? You probably are exaggerating how much more you’ll have to spend in retirement if the markets go your way.
The most surefire way of improving your retirement standard of living is working longer.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.