Nestegg Cycle © AARP Suggests: Contribute 2% More to Retirement. Should I?
Posting Date: November 04, 2022
The AARP (American Association of Retired Persons) began running a
public service announcement during the Summer of 2022,
targeting poor to middle-class working women with this message:
You budget. You pay bills. You build up funds for a rainy day like it’s your job.
Now, you can save for your future by just setting a goal to save 2% more of your income for your retirement.
Why 2%? Because 1% honors you and 1% honors all womankind.
As soon as we heard this, we realized it would be useful to analyze, and determine
whether a 2% bump in savings rate, would actually provide a significant amount of help, or not.
The short story is that the amount of benefit derived from an extra 2% salary contribution
DEPENDS STRONGLY UPON THE INVESTMENT YIELD THAT MONEY WILL EARN;
At low-end yields,
(see top rows of the table below, where the yields are 0.10%, and 1.50%)
that benefit is NEGLIGIBLE, so that the priority must be to move the money to higher yielding investments,
followed by raising the contributions!
Our concern is that many of the women in the target audience could be in this situation and unaware of it.
Without better customized advice, these women
will derive a false sense that they are doing enough, when they are not even close.
At high-end yields, (see bottom rows of the table below,
where the yields are 9.0% and 10.50%)
each extra 2% of contribution has an enormous impact toward the 50% salary replacement goal,
supplying about 49% of the total needed at 9.0% interest, and about 83% of the total needed at 10.5%
In between, at yields of 4.5%, 6.0%, and 7.5%, you can see that the contribution of an extra 2%
has a noticeable impact, although far from being enough in itself.
We combined and interpolated from many runs of the
NesteggCycle.Com Calculator, to produce the following table.
We assumed a worker starting their savings/career at age 25, retiring at 65,
with enough money to last until age 95;
We assumed inflation of 2.5%, annual raises of 3.0%, and no prior savings.
We specified a goal retirement with
first annual payout replacing 50% of final year's salary,
plus COLA's to match the 2.5% inflation.
In the table below, and throughout this posting, "SalRep" is short for Salary Replacement in this sense.
Col A Col B Col C Col D
Invest Contrib% for SalRep from Multiple for
Yield% 50% SalRep 2% Contrib 50% SalRep
0.10 91.33 1.0949 45.67
1.50 56.65 1.7652 28.33
3.00 33.80 2.9586 16.90
4.50 20.05 4.9875 10.03
6.00 11.85 8.4388 5.93
7.50 7.00 14.2857 3.50
9.00 4.12 24.2895 2.06
10.50 2.42 41.3779 1.21
Where: Col A = Annual Yield being earned by the contributed retirement money.
And: Col B = Percentage of salary which must be contributed toward retirement to satisfy 50% SalRep at this Yield.
And: Col C = 2% times (50%/(Col B)) = 100%/(Col B)
The extra Salary Replacement (SalRep) produced by an extra 2% Contribution.
And: Col D = 50%/(Col C)
The Number of such 2% Contributions required to produce 50% SalRep.
AT 0.10% Yield, a 2% contribution is insignificant: you need 45.67 of them.
At 10.5% Yield, a 2% contribution is almost all you need: 1.21 of them.
NOTE: A useful shortcut is that, at any given Yield, the contribution is proportional to the SalRep desired.
Thus if you seek 25% SalRep instead of 50%, you can divide the Col B and Col D values in half.
OR, if you seek 75% SalRep instead of 50%, you can multiply the Col B and Col D values by 1.50.
The rationale for these choices can be found in our earlier posting
HERE
which discussed the devastating retirement shortfalls caused by the combination of low investment yields
and low contributions.
Because this analysis utilized the so-called "4% Rule",
original study by Bill Bengen in 1994,
and discussions in this blog series
Part1 HERE
and
Part2 HERE,
a payout term of 30 years was assumed, ages 65 thru 95.
Your personal situation may be different, and we normally suggest calculating out to age 105.
In fact, younger workers, in their 20s or 30s now, are advised to go higher, age 110, to allow for advances in longevity.
It is important to be clear that a "2% contribution" means an entire year of 2% contributions from every paycheck.
THUS, if you get 24 paychecks per year with 2% contributed from each one, that is still 2%, and NOT 48%.
FIRST QUESTION TO EVERY READER: Do you have a well-reasoned GOAL for your SalRep in retirement?
We have used 50% for the SalRep calculations in this posting, but your situation might call for more, or less.
It is easily worth a few of hours of your time to get this right, including both research and soul-searching.
While waiting for a good time to do that research and soul-searching, however, we do suggest 50% SalRep
as a good solid start.
You will at least be in the right "ballpark", but would benefit by customizing to your own situation.
Most workers in the USA pay into a government pension system called Social Security.
The amount of salary replacement you can expect in your own case, depends strongly on your salary history
and the number of years you contributed into the system before claiming retirement benefits.
As a general rule, lower salaried workers can expect a much higher percentage of salary replacement
from Social Security benefits, with the percentage declining as average salary increases.
This article shows some average salaries and approximate replacement rates from Social Security benefits,
but, your most reliable information comes from your own individual benefit projection report,
from the Social Security Administration (SSA).
From your own run of the
NesteggCycle.Com Calculator,
you can find a pair of lines similar to this one:
Multiplier of Salary & Prices during 40 working years:
Salary: 3.1670 Prices: 2.6196 Spend_Power: 1.2090
which is based on the number of working years you specified (40 years in our example, from ages 25 to 65)
as well as your entered best guesses (or site-provided defaults) of 3.0% raises and 2.5% inflation.
Your salary will have grown by the factor shown (here, 3.1670).
Multiply your current salary by this factor to estimate your final salary at retirement.
Your first but extremely rough guess at your SalRep requirement from your retirement nestegg, would be
[ (your estimated final salary) minus (your personal benefit estimate from the SSA) ]
divided by
(your estimated final salary)
and will usually be somewhere in the range of 25% to 75%.
Refine this further by including any other income streams you expect to have, such as another pension or a
side business. These will reduce the amount of salary you need to replace using your nestegg. On the other hand,
you may also expect your lifestyle expenses to change up or down depending on personal choices you want to make,
or from changes to your health, etc. Estimate these and re-adjust what you'll need from your nestegg.
As a practical example, suppose you were previously contributing 3% of your salary
and you want to evaluate the effects of adding another 2%, taking you to contributions of 5%.
Assume for this example, that you are staying with the goal salary replacement (SalRep) of 50%.
To validate your own situation, supply your own ages, your existing savings, and your own other expectations, and
run the
NesteggCycle.Com Calculator,
supplying
5.0 as the central value of a Custom Contribution Range,
and
2.0 as the step (increment) value.
To do this,
Select "Custom" from the dropdown list to right of "Contribution Range" on the screen, explained
HERE
to see whether the yields that it requires, both before and after, are within your reasonable expectations.
Here is an excerpt from this calculation using the same inputs as throughout this posting:
Min Yield required for Custom_5_2 Range Salary Contribs:
contrib: yield: sav/sal: withdrw:
3.00% 1 9.890% 6.077X 8.229%
5.00% 1 8.447% 7.030X 7.112%
7.00% 1 7.496% 7.798X 6.412%
9.00% 1 6.784% 8.461X 5.910%
11.00% 1 6.215% 9.056X 5.522%
13.00% 1 5.739% 9.600X 5.208%
15.00% 1 5.332% 10.109X 4.947%
Questions to ask yourself, working from these results:
My current contributions of 3% require an investment yield of 9.890% ...
AM I earning that now?
IF YES, I do NOT need the 2% bump-up of my contribution!
IF NOT, can I re-invest elsewhere to earn that much, and still sleep at night?
My proposed contributions of 5% require an investment yield of 8.447% ...
AM I earning that now?
IF YES, the 2% bump-up resolves my retirement shortfall!
IF NOT, can I re-invest elsewhere to earn that much, and still sleep at night?
IF STILL NOT, I'll need to step up my contributions even more,
and/or
seek higher yielding investments,
and/or
lower my SalRep expectations.
Suppose I know that my current yield is LOW, somewhere among the topmost entries of the first table.
It is obvious that an extra few percent of contribution will not do the job, so we'll try casting a wider net.
We can select the on-screen MEDIUM or HIGH contribution range option to scope out our situation.
Here, we use the on-screen HIGH contribution range option (30% - 85% by 5's):
Min Yield required for High Range Salary Contribs:
contrib: yield: sav/sal: withdrw:
30.00% 1 3.344% 13.244X 3.776%
35.00% 1 2.899% 14.133X 3.538%
40.00% 1 2.512% 14.974X 3.339%
45.00% 1 2.170% 15.776X 3.170%
50.00% 1 1.864% 16.546X 3.022%
55.00% 1 1.586% 17.287X 2.893%
60.00% 1 1.333% 18.006X 2.777%
65.00% 1 1.099% 18.704X 2.674%
70.00% 1 0.882% 19.382X 2.580%
75.00% 1 0.680% 20.045X 2.495%
80.00% 1 0.490% 20.693X 2.417%
85.00% 1 0.312% 21.327X 2.345%
PLOT EXTENDER IN EFFECT: Hi-C
The object of this execise is to find a "sweet spot" for funding your retirement:
An investment yield that lets you sleep at night but works hard enough to avoid budget-busting contributions ...
To reach your carefully considered salary replacement goal.
Notes for late 2022:
It appears that at least for some time to come, we may be living with higher inflation,
and lower expected market yields.
This may call for a sobering re-evaluation,
since each of these factors tends to force lowered expectations as to the results you can comfortably achieve.
One beneficial effect for savers is that bank interest rates have been climbing in the past few months and are
expected to climb farther.
There are a few banks offering 4.00% yields and more now, in early November 2022,
with many more in the mid-3's.
Shop!
Some good CD-rate shopping sites:
DEPOSIT_ACCOUNTS
and
BANKRATE.
Disclaimer:
This is mathematical calculation only, and there is no guarantee, express nor implied,
that real-world conditions will cooperate with the math. Your results may vary!
We do not vet nor endorse any banks at the shopping sites mentioned. You must perform your own due diligence!
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