This week we’re looking at what it takes to save enough for a comfortable retirement. Or, expressed more broadly, what’s needed to have financial security. I got plenty of feedback on the article asking “How much do you need to retire?”. The uncomfortable answer is rather a lot. Today I’ll start looking at how to get there – first by examining whether you can rely on the government.
Last time I estimated that investment capital of around $1 million, making 5% a year on average, is about enough for an annual retirement income of $50,000 that increases with inflation and lasts for 20 years. At the end of that there would be little or nothing left.
Put another way, for every dollar of net income you think you’ll need in retirement, you should have built up about $20 of investment capital. And even then, if you want the money to last, you’ll need to keep those funds invested and making a profit. These days your retirement – or semi-retirement – could last two or more decades.
Building up a fund of that size seems like a mountain to climb. In fact it is. But it’s certainly not impossible. It just requires a combination of making saving a priority, paying off debts quickly, starting as early as possible, and having a decent and long-term investment strategy.
Many people just assume that government retirement schemes, such as social security or state pensions, will be enough. Or even enough for a large part of future needs. That may be true today, but as you’ll see it’s unlikely to be the case future, perhaps in as little as 10 or 20 years’ time.
I had quite a bit of reader feedback on the earlier article. Here are a couple of short extracts that capture the overall gist.
First here’s George T. from the USA: “Great article. Since I am semi-retired now your article hit a chord…Maybe you could follow up with an article on how to get there…Your article did not take into account social security (US) or national insurance (UK).”
And here’s Peter T. from Australia: “Future state pension entitlements are simply a state debt. Successive governments have successfully inflated away a large part of all state debts…Life is to be lived and not endured. Forget retirement. Think freedom or at least being more free and start with the mind.”
Both these gentlemen write to me from time to time, and both always have interesting input. (Thank you gents, and please keep it coming. I encourage all readers to send in their thoughts.)
Let’s start with government pension programmes. Most countries – at least developed ones – have some kind of system. The details vary a lot by country, but one thing in common is that they’re usually too complex.
…a government promise to make some kind of future payments to people above a certain age, often subject to conditions. This makes them a government debt, although they are rarely acknowledged as such in government accounts.
These schemes are invariably a government promise to make some kind of future payments to people above a certain age, often subject to conditions. This makes them a government debt, although they are rarely acknowledged as such in government accounts.
(Whereas government regulations insist that all private corporations report full estimates of unfunded pension liabilities! Talk about double standards…)
Since government sets the rules it also means a future government can rewrite the debt contract if they so choose (and so choose they do and will – frequently).
“You assumed you could stake your claim when you reached 65? Sorry, we just changed that to 68 years old.”
“You thought your lifetime of contributions would entitle you to that many thousand a year? No, no, no, we’ve changed the calculation – you know, it’s a complex actuarial thing – and reduced it to just this much.”
“You expected the payments to go up each year with inflation? Yes, that will still happen, but we’ve “improved” the way we calculate price rises and it turns out that inflation is less than we previously thought. Imagine our surprise!”
These kinds of things may seem fanciful. But they’re happening in one way or another across the developed world, as populations age and the burden of pension promises becomes ever greater each year.
The US and UK government-organised pension systems are different, but they have one thing in common. Workers and their employers pay “contributions” each month – which are simply an extra income tax – and the government promises to pay back a certain amount at the end, subject to various conditions.
In the case of the US the system is called “social security”. Contributions are a percentage of earnings up to a cap, and the final payout is linked to how much was paid in over the years, also up to a cap. In 2015 the average annual payout to retirees was $15,936, and the maximum was $31,956. Payments rise along with official inflation.
The UK pays a “state pension”, in theory funded by an extra income tax on workers and employers called “national insurance”, which has a cap. The payout isn’t linked to how much was contributed, just to how many years the payments were made for.
Under the newest UK rules, if a pensioner has paid for 35 years they’ll get the maximum state pension of £8,094 a year (equivalent to $11,898). Since 2010 that’s increased each year according to a “triple lock”, meaning it rises according to the higher of increases to average UK earnings, official price inflation or 2.5%.
If that last part sounds too good to be true, then that’s because it is. I doubt the British triple lock will last for long, as it’s just too expensive.
If you’re close to retirement, or already retired, these government schemes will probably provide a decent income base. For each $10,000 (or £) they pay out you’d need around $200,000 (or £) of private investments to get the same result for 20 years, with nothing left at the end.
But neither scheme is “funded”, meaning there isn’t a pot of money that’s been invested on your behalf. The US does a better job of hiding this fact behind smoke and mirrors, because the future payment promise is linked to how much has been contributed in the past.
Nonetheless the money contributed each year goes to the US government, is pooled with other taxation, and is spent straight away – whether on pensions or anything else. At the same time the government issues a debt to the social security “fund” – an IOU.
Currently this IOU is around $2.9 trillion. By the early 2020s the payouts to retirees will start to exceed the new contributions from workers, meaning the US government will get less from contributions than it has to pay to retirees (for the first time).
It’s projected – by the government itself – that the reported “fund” of mirage money will have run dry by about 2033. In other words, the Federal government will have to borrow $2.9 trillion from elsewhere by then (or print it), to cover the cash shortfall. How’s that for “security”?
At least the US government admits at least part of its future pension liability, being the $2.9 trillion shortfall between now and 2034 (even if that’s not how they describe it). But even that excludes the much larger future liability for the following decades – unless the payouts are drastically cut (less expense), or the contributions are drastically increased (higher taxes).
The British government doesn’t even admit a portion of the future pension liability in its accounts – in common with most governments. All the current tax money is spent, and future pension costs will have to be met with future taxation and borrowing.
For now these creaky systems pay out something. But it’s far from certain that they’ll pay anything nearly as “generous” in 10, 20 or 30 years time – once adjusted for price inflation. In fact it’s pretty unlikely, given ageing populations and already stretched government budgets.
Today most retirees need private sources of income to live well, even if they get something currently from these schemes. That means private pensions or other non-pension investments – or part time work (subject to health, or course).
In any case, you shouldn’t rely on your government for your retirement money, wherever you live. Today most retirees need private sources of income to live well, even if they get something currently from these schemes. That means private pensions or other non-pension investments – or part time work (subject to health, or course).
And if retirement age isn’t yet upon you then I’d bet you’re going to need a bigger share to come from private income than current retirees, as state organised schemes struggle to keep up with the demands on them.
As an aside, there’s a better (although not ideal) model in some other countries. This is where all employees must contribute, by law, a certain amount of their salary into a tax-free pension fund each month. The money is invested in their own name and they can choose how it’s invested – at least to some extent.
Two countries with versions of this sort of scheme are Australia, since the early 1990s, and Chile (yes, Chile!) since the 1980s. Put in US terms, it’s like having a compulsory 401(k) or IRA instead of social security.
Of course I don’t like the compulsory aspect. There should be an opt out. But given the choice of paying tax money into a government black hole and paying it into my own pension fund, however imperfect, I know which I’d prefer.
It seems pretty clear that all of us need to make private provision if we want to have financial security as we age. Even if you plan to keep working for longer, even part-time, don’t forget that health problems could put a stop to that. Building up substantial investments over time is the only answer.
Next time: more on how to get there.
Stay tuned OfWealthers,