What Your Parents Didn’t Tell You About Saving for Retirement

Anne Bucciarelli

Chances are, your parents have told you to max out your 401(k) plan. That’s good advice, but the hard truth is that your 401(k) plan is highly likely to fall short. To live comfortably in retirement, our research shows, you will almost surely need more.

Wide of the Mark

Let’s assume you’re a 30-year-old single tax filer with a substantial pretax salary of $100,000 a year, and that your salary will increase 5% a year until you retire at age 65. We’ll also assume, for simplicity’s sake, that until you retire, you’ll have a growth-oriented asset allocation with just two asset classes: 80% invested in global stocks and 20% in intermediate-term, taxable bonds. After retirement you’ll have a moderate asset allocation, with 60% in stocks and 40% in bonds.

Maxing out your 401(k) plan means contributing $17,500 in 2014. You’ll be able to contribute more in future years because the limit is indexed to inflation. At this contribution level, you’ll take full advantage of matching contributions from your employer. Since these can vary widely, we’ll assume the typical level, which is 6%* of each paycheck. We’ll assume, as well, that you’ll take full advantage of “catch-up” rules that, after age 50, allow you to contribute an extra $5,500 a year (adjusted for inflation) to your 401(k) plan.

In this scenario, after 35 years of average market returns, you would have inflation-adjusted wealth of $2.2 million in your 401(k) plan. Not too shabby, you might think. But will this actually be enough to support your lifestyle?

Probably not. If your retirement extends for 30 years (to age 95), we calculate that you will be able to spend only $73,000 a year in inflation-adjusted dollars from your 401(k) without running the risk of depleting your account if markets are hostile. As Display 1 shows, in typical or great markets, you’ll still have significant assets at age 95, but in hostile markets, $73,000 is the most you can sustainably spend each year. Bear in mind that after all those 5% annual increases, your final inflation-adjusted salary would be $190,000. In other words, you would be living in retirement on about 38% of your final salary. This is not likely to be pleasant.

If you contribute less than the maximum to your 401(k), you’re likely to be even less satisfied. In fact, one-third of US employees put just enough into their plan to qualify for a full employer match.* If you make 6% annual contributions and receive a 6% match from your employer, your sustainable spending in retirement would be just $45,000 a year, or 24% of your final salary.

Of course, if you max out your 401(k) and you’re fortunate enough to live through a period of outstanding investment returns, your results could be much better. Great markets could leave you, at age 65, with $4.6 million after inflation, or more than twice the median amount. You’d be much more comfortable, but we estimate that there’s just a one-in-10 chance of an outcome this favorable. It’s not something you can bank on.

Improving Your Odds

Once you’ve maxed out your 401(k), what more can you do? We have three suggestions:

If your employer offers a Roth 401(k) option…

It could help a lot. The maximum contribution is the same for a traditional 401(k) and a Roth 401(k), but their tax treatment is different. With the traditional 401(k), you contribute pretax dollars, and growth of your portfolio is not taxed. But once you start taking money out of the account, your withdrawals are taxed at your ordinary-income rate. With the Roth 401(k) you contribute after-tax dollars, but you pay no further tax on portfolio growth or withdrawals.

If your tax rate doesn’t change, the tax treatment shouldn’t make a difference—except that an after-tax contribution of $17,500 is, in effect, much larger than a pretax contribution of the same amount. If you max out your contribution, the Roth 401(k) will support sustainable retirement spending of $102,000 a year, inflation-adjusted—a hefty 40% more than the traditional 401(k) (Display 2).

Fortunately, there’s a growing chance that you’ll have a Roth 401(k) option. Six years ago, just 11% of employers offered it. Today, 50% do.*

If you want to work longer…

Working past the age of 65 could make a sizable difference, both because you’ll enlarge your portfolio with additional contributions and because you’ll draw on your savings for fewer years of retirement. But extending your retirement date does mean sacrificing some years of (likely active) leisure.

If you can save more…

If you’re already putting the maximum amount into your 401(k) account and are able to save even more, you could set up a taxable investment account to house your annual bonuses and incremental savings.

If you want to be able to spend as much in retirement as you’ll be spending in your last working years, under typical market conditions you’ll need to supplement your $2.2 million 401(k) account with $1.6 million in taxable assets. To save that much, you’ll likely have to sacrifice some present pleasure for greater future security. That’s a decision only you can make.

*Source: Aon Hewitt

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions.

Anne Bucciarelli, CFA, is an Associate Director in the Wealth Planning and Analysis Group at Bernstein Global Wealth Management, a unit of AllianceBernstein L.P. (NYSE:AB)

3 comments

  1. Is the $73k projected max withdrawal net or gross (of income tax)?

    What are the actual numerical values for “great” “typical” and “hostile” returns?

    • Anne Bucciarelli

      In answer to your first question, the $73,000 of maximum spending is after tax.

      With regards to your second question, unlike linear models that apply specific point values to project future results, our Wealth Forecasting System (WFS), like other Monte Carlo simulations, generates 10,000 plausible outcomes. Additionally, and unlike other Monte Carlo models, we take into account today’s capital market conditions, using expected future return projections, as well as the correlations between asset classes. These outcomes are then arranged from worst to best so probabilities can be measured at any chosen point. We tend to focus on the 10th percentile (great markets) the 50th percentile (typical markets) and the 90th percentile (hostile markets). In today’s capital market environment, the output of the WFS is equivalent to a compound annual growth rate of 11.8% in great markets, 7.7% in typical markets, and 3.9% in hostile markets for an 80/20 portfolio over 35 years. But these numbers will almost certainly change next quarter or next year, as current conditions change.

  2. Great article which sheds light on the reality which is obscured by inflation, extended mortality and implied the need to generate investment returns which is also something that also cannot be counted on.

Leave a Reply

Your email address will not be published. Required fields are marked *

*

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>