40. Safe Savings Rates

Safe Savings Rate Whitepaper by Wade Pfau

A Listener asks - how much should I be saving?  What is a %'age goal per age group

    · Traditional rules of thumb around retirement savings have focused on safe withdrawal rates

    · This model, if you can take an inflation adjusted 4% from your portfolio for life, you simply calculate what your accumulation target is and then make that your savings goal

    · Ie. If you want to take out $40,000/year from your investment portfolio and adjust it for inflation, you would simply need to divide that amount by 4%, and that gets you to your $1m capital requirement

        o This would be added to your pension or CPP/OAS entitlements

    · Is approach was made famous by Bill Bengen and research he completed in the early 90's

    · The challenge for savers is that this is very "outcome focused", specifically:

        o For a young saver, that amount can seem onerous 

        o For a mid-career saver or even late career saver you can get overly optimistic or pessimistic based on fluctuations

    · The other challenge was that a 4% withdrawal rate can give you a very different experience depending on what year you retire in – the results were very “noisy” depending on when you retired

                o For example, a US retiree who retired in 1999 with $1M would be told to take $40,000/year as their retirement income

                o A US retiree who retired in 2000 with $800,000 would be told to take $32,000/year

                o The danger in this approach is that the 1999 retiree, with the runup in equity prices leading into 2000, may have “retired early” and had to cut back on retirement expenses if they were withdrawing too much

    · Wade Pfau, a retirement researcher from the US, attempted to address these issues by creating something he called the safe savings rate

    · The goal of the research was to establish a savings rate expressed as the %’age of your working income that you would need to save throughout your working life so that you would be able to retire at your desired income replacement level and not run out of money, regardless of what the markets did before you retired and during your retirement

    · For his base case, he set out to determine the safe savings rate for a 30 year career followed by a 30 year retirement, with a 50% replacement rate, and a 60% stock/40% bond portfolio

    · The research identified a ranging from 16.62% (1918 retiree) and 9.34% (1920 retiree)

        · For rounding purposes, we will call the safe savings rate 15% of your pre-tax income to replace 50% of your pre-retirement income for a 30/30 retiree

    · Recognizing that not everyone follows a 30/30 pattern, he adapted the research for different career lengths, retirement lengths, income replacement rates, and asset allocations

    · Wade points out the limitations of this research, which include:

        · It doesn’t adjust for asset allocation changes between pre and post-retirement phase

        · It is a two asset class portfolio, some benefits to global diversification

        · Assumes a constant rate of savings and a constant income, neither of which is very common

            · Ie. job changes, starting a business, having a baby, getting an inheritance, getting a bonus – all of these things cause savings rates to ebb and flow

        · This research doesn’t account for portfolio management and product fees (will make a big difference)

        · The research assumes serial correlation, meaning that the pattern of how markets ebb and flow in the past would need to be similar in the future, which is highly unknowable and that's why we use things like monte carlo simulations - we only have 2 non-overlapping 60 year periods of history to draw from 

    · Wade himself says

        · “The savings rate does not need to be fixed, as individuals can make projections for their future income, unique consumption needs such as raising children or paying for a home, and retirement expenditures.  Allowing for consumption smoothing needs, these projections can be calibrated with a variable savings rate needed to fit the planned pattern of lifetime savings.”

    · My thoughts 

        · I like things that are more focused on behaviour, so I like this approach for that reason

            · Setting an objective to save between 10%-15% of your income is probably healthy and a great pattern of behaviour for a young saver

        · In real life, it's always messier than that

            · Kids, houses, unexpected expenses, promotions

This is why I'm a big fan of customized financial planning for each individual