Note: This article is part of Morningstar's 2019 Portfolio Tuneup week. A version of this article appeared on Jan. 22, 2018.
If you want to get yourself thoroughly depressed, spend a little time looking at statistics about Americans' retirement preparedness. Some of the data are hopeful. Recent research from the Employee Benefit Research Institute, for example, finds that 6 in 10 American workers feel confident in their ability to retire comfortably. And people are saving more.
But other data are more sobering. Fidelity's Retirement Preparedness Measure, which takes into account current savings rates and account balances, shows that less than half of all Americans are going to be able to maintain their current standards of living in retirement. A report from the U.S. Government Accountability Office noted that about half of all Americans age 55 or older have no retirement savings, such as IRAs or 401(k)s.
Clearly, many people are hurtling toward a shortfall, or living through one. And for people who are dramatically undersaved and largely reliant on Social Security for in-retirement living expenses, there's no getting around the fact that their standard of living in retirement is going to be lower than it was when they were working.
Many other workers have some retirement savings--just not enough. I've noticed that people in that position tend to adopt one of a handful of tactics. The first set is defeatist: "My kids will just have to take care of me." The second set is scrappy: "I'm just going to keep on working." The last group of people are looking to their investment portfolios to do the heavy lifting, hoping against hope that some combination of the right asset allocation and good investment picks will help make up for the shortfall. ("If I can just hit a home run with an investment or two …")
I'd propose a fourth course of action. Rather than looking to a single blockbuster solution to help make up for a savings gap, what if you were to consider a little bit of several prudent strategies--being willing to cut your standard of living a bit in retirement, working a bit longer, and investing a bit better, for example? The virtue of taking several small steps--rather than relying on a single Hail Mary action--is that if one of the variables doesn't play out as you thought it would, you may still be able to save your plan. Employing more modest changes around the margins of your plan means they're apt to be more palatable from a lifestyle perspective, too; the thought of working until age 70 might not appeal, but holding out until age 67 may be more do-able.
Meet the Shortfall Coverers
Before I get into a case study examining how several steps together can help put a plan on track, let's first run through the key variables that investors have to choose from if, based on their current savings and savings rates, it looks like there's a risk that their retirement assets will fall short. Remember, you don't necessarily need to embrace each of these, but implementing several of these tacks together can help bridge a shortfall. Using an estimate of your Social Security benefit, as well as a good basic savings calculator, you should be able to fiddle around with the variables to help assess the payoff that each one delivers.
As pre-retirees have no doubt heard, working even a few years past traditional retirement age can deliver a three-fer on the financial front, allowing additional savings, fewer years of portfolio drawdown, and perhaps delayed Social Security filing. Being willing to work part-time in retirement is another variation on this idea. Yet as attractive as working longer looks by the numbers, it's a poor idea to make it the sole fallback plan, as many who plan to work longer are not able to.
Delay Social Security
This is another exceptionally powerful lever, allowing individuals to pick up a roughly 8% increase in benefits for every year they delay Social Security filing beyond their full retirement ages up until age 70. In order to pull this off, however, an individual may need to work longer or draw from a portfolio earlier.
Save More Before Retirement
The good news is that from a household budgetary standpoint, many individuals are best equipped to crank up their savings rates later in their careers. They're often in their peak earnings years, and other big-ticket pre-retirement expenses, such as home purchases and college funding, may be in the rearview mirror. The bad news is that with a shorter time horizon, those newly invested dollars will have less time to compound before they'll need to withdraw them; the tax benefits that one gets from using tax-advantaged retirement savings vehicles like IRAs and 401(k)s also matter less (especially for tax-deferred contributions that entail RMDs) later in life. That doesn't mean that late-start retirees shouldn't bother with additional contributions if they can swing them, though: Even an additional $5,000 invested per year, earning a modest average return of 4%, would translate into more than $60,000 additional dollars in retirement. This interview discusses turbocharging retirement savings in the "empty nest" years.
Spend Less During Retirement
Generally speaking, people who earned higher incomes in retirement will have more wiggle room in lowering their in-retirement expenses than people with lower incomes. The simple reason is that the former group is apt to have more discretionary expenses--and therefore could do more belt-tightening--than the latter group, as discussed here. Being willing to relocate to a cheaper home and/or a less-expensive location, while not for everyone, can deliver one of the biggest-ticket cost savings available to retirees.
Many pre-retirees confronting a shortfall focus their energies here, and certainly a portfolio with a heavier stock mix will tend to have a higher long-term return than a more conservative one. Yet it's a mistake not to temper a pre-retirement portfolio's asset mix with safer investments, and that's particularly true in market environments that feature not-cheap equity valuations (like the current one). If a retiree's equity portfolio falls sharply in the first years of retirement, that can permanently impair the portfolio's ability to sustain itself over the retiree's time horizon.
Lower Investment Costs
This one's a gimme. Lower mutual fund expenses are correlated with better returns, so why wouldn't you work to bring your portfolio's total costs down? Lowering costs can be particularly advantageous as you enlarge your portfolio's stake in safer investments like bonds, where absolute investment returns are apt to be fairly low and the differential between very strong and very poor performing investments can boil down to expenses.
A Case Study: Before
To take a closer look at how adjusting a combination of the above variables can help bridge a retirement shortfall, let's consider a hypothetical 58-year-old pre-retiree, Cassie. Here are the particulars of her retirement situation.
- She earns $50,000 a year and expects to need $40,000 per year when she retires
- She hopes to retire at age 66
- If she begins Social Security benefits at age 66, she'll get about $23,000 per year
- She has $140,000 in her company 401(k) and $25,000 in her rollover IRA
- She invests $12,000 in her 401(k) per year (her own contributions plus match)
- Her total stock/bond mix is 30% stock/50% bond/20% cash
- Her portfolio's expected return over the next 10 years: ~3%
- Her portfolio's estimated value if she retires at 66: $315,725
- Amount available after taxes (assuming 25% tax bracket): $277,838
- "Safe" withdrawal rate, year 1 of retirement: $11,114
- Income from Social Security and portfolio in year 1 of retirement: $34,114, well shy of her $40,000 target
A Case Study: After
Tweaking Cassie's investment portfolio to improve its return potential is one idea, especially given that she's not retiring imminently. It would be a mistake to expect miracles on the return front, especially in the near term; I'd strongly caution against employing heroic return assumptions of 5% or more, or gunning for higher returns by taking the equity weighting over 75%. But by moving money out of cash she may be able to nudge up her portfolio's long-term return potential a bit, from 3% to 4%. The other adjustments--increasing contributions and delaying retirement and Social Security--will require more sacrifices, but do even more to help bridge Cassie's retirement shortfall. Her plan can come together if she takes the following steps.
- Cassie can find another $3,000 to invest in 401(k) each year until she retires (this is, of course, a heavy lift given her salary)
- Delays retirement to age 70
- Delays Social Security to age 70 (Social Security benefit increases to $35,000 per year)
- Changes her stock/bond mix to 60% stocks/40% bonds (potentially increases portfolio's expected return to 4%)
- With a higher expected return and higher contributions for a longer time, her portfolio's estimated value at retirement is $489,557
- Amount available after taxes (assuming 12% tax bracket): $430, 810
- "Safe" withdrawal in year 1 of retirement: $17,232
- Income from Social Security and portfolio in year 1 of retirement: $52,232, over her $40,000 target