Savings: The Simple Key to Retirement Income

Many young workers are worried about how they will be able to retire, particularly with uncertainty about the long-term future of Social Security. And even if Social Security benefits are sustained for older workers, many are still concerned that their retirement savings are unlikely to provide sufficient additional income.

Their worries are more than reasonable. Most Americans are not financially prepared for retirement. More than half of all workers say they have less than $25,000 in total savings and investments, excluding the value of their homes, and 28% report less than $1,000, according to a January 2013 survey by the Employee Benefit Research Institute.

For both young and old, the solution may be challenging, but it is very simple: saving enough. It’s hardly a new or sophisticated concept, but there’s usually no way around it—if adequate retirement income is the goal.

“The single most important action that you can take right now is to ensurethat you are saving enough,” says Stuart Ritter, a T. Rowe Price senior financial planner. “And that doesn’t mean just enough to get the match from your employer’s 401(k) plan. It means saving at least 15% of annual income, including your employer’s match.

“Saving enough trumps almost all other considerations—because if you’re not putting enough away, everything else is secondary.”

Late Savers

A new T. Rowe Price study shows that for older workers facing potential retirement income shortfalls, the more likely path to greater retirement security is increasing savings, or possibly delaying retirement, rather than assuming greater investment risks—as many may be tempted to do by raising their allocations to stocks (which historically have provided higher returns over periods of 10 years or more).

If possible, older workers should take advantage of the 401(k) “catch up” savings provision to increase their savings rate or even delay tapping their investments by working longer.

Those 50 and older can save $23,000 in a 401(k) plan in 2013—$5,500 more than the $17,500 limit for younger workers. They can also contribute an additional $1,000 to an individual retirement account (IRA) above the maximum of $5,500—or $6,500 in all. As shown in the chart below, a 55 year old, with $450,000 saved and putting away 15% of her salary until retirement at age 65, is not likely to increase her retirement income by boosting her stock allocation from 60% to 80% of her portfolio—although that would tend to raise her chances of having a higher savings balance over the course of her retirement years. (See the disclosures on the chart below and the RIC Monte Carlo simulation disclosures at the end of this post.)


Source: T. Rowe Price

But saving more can only raise initial retirement income by so much for those approaching retirement because there is not that much time for investment returns to compound before retirement.

So the highest retirement income in the study was achieved by the worker who kept saving 15% of annual salary but also then delayed retirement. As in the chart, the worker who delayed retirement five years with a 60%/40% stock/bond allocation and 15% savings rate boosted her initial retirement income to $40,440—a 37% increase compared with retiring at 65.

“For older workers in particular who are trying to build their retirement income, their asset allocation strategy should not be their first consideration, unless they currently have less than 40% of their retirement portfolio invested in stocks,” says Christine Fahlund, a T. Rowe Price senior financial planner. “Increasing their equity allocation is not likely to have that much impact between now and the time they retire.”

Ms. Fahlund advises that working longer is generally “most impactful. Delaying retirement even two or three years provides significant benefits. First, it allows more time for savings to compound in a tax-deferred account. Second, it gives the investor more time to add to the account. And, third, each year retirement is delayed is one less year of tapping assets in retirement.

“It’s never too late to start,” she adds. “Just keep in mind that working a little longer and saving a little more should prove more beneficial than taking on more investment risk for those trying to make up for lost time.”

Early Savers

Of course, retirement savers who start early enough can provide themselves with a lasting leg up on late savers trying to catch up.

For those just starting their careers, the power of putting time on their side by saving early cannot be overemphasized.

As shown in the chart below, a 22 year old who invests $100 a month for 10 years and then stops investing could accumulate more than someone who delays saving for 10 years and then contributes $100 a month for more than 30 years until 65—even though the investor who started early only invested $12,000, while the investor who started later invested almost $40,000.

Judy Ward, a T. Rowe Price senior financial planner, says that—while it’s important for parents to talk to their kids about money at any age—the discussion may take on more relevance as they begin their working careers as young adults.

A good place to begin is to make sure they understand “interest on interest”—the benefit of compounding. Compounding increases may be modest at first, but over time they could dramatically accelerate wealth accumulation.

Beyond 401(k) workplace savings plans, Ms. Ward encourages young workers to consider opening a Roth IRA as soon as possible. Contributions are made with after-tax income, so distributions of principal are not subject to income tax or penalty. Earnings in a Roth IRA are income and penalty tax-free if withdrawn after age 59½ and if the owner has held any Roth account for five years.

Roth IRAs are particularly attractive for young workers because the assets in the account have more years to compound before they are potentially withdrawn income tax-free.

If a young adult retiring in 30 years makes an initial contribution of $1,000 to a Roth IRA and adds $100 a month until retirement, she could have more than $250,000—all tax-free under certain conditions, Ms. Ward notes, assuming a 7% annual investment return.

For more guidance on discussing savings with young adults, a video of Ms. Ward chatting about saving with her son, a recent college graduate, can be viewed at


Monte Carlo Simulation

Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability, thus incorporating future uncertainty.

Material Assumptions Include:

• Underlying long-term rates of return for the asset classes are not directly based on historical returns. Rather, they represent assumptions that take into account, among other things, historical returns. They also include our estimates for reinvested dividends and capital gains.

• These assumptions, as well as an assumed degree of fluctuation of returns around these long-term rates, are used to generate random monthly returns for each asset class over specified time periods.

• The monthly returns are then used to generate 1,000 scenarios, representing a spectrum of possible return outcomes for the modeled asset classes. Analysis results are directly based on these scenarios.

• Required minimum distributions (RMDs) are included. In the simulations, if the RMD is greater than the planned withdrawal, the excess amount is reinvested in a taxable account.

Material Limitations Include:

• The analysis relies on return assumptions, combined with a return model that generates a wide range of possible return scenarios from these assumptions. Despite our best efforts, there is no certainty that the assumptions and the model will accurately predict asset class return ranges going forward. As a consequence, the results of the analysis should be viewed as approximations, and users should allow a margin for error and not place too much reliance on the apparent precision of the results.

• Extreme market movements may occur more often than in the model.

• Some asset classes have relatively short histories. Actual long-term results for each asset class going forward may differ from our assumptions, with those for classes with limited histories potentially diverging more.

• Market crises can cause asset classes to perform similarly, lowering the accuracy of our projected return assumptions and diminishing the benefits of diversification (that is, of using many different asset classes) in ways not captured by the analysis. As a result, returns actually experienced by the investor may be more volatile than projected in our analysis.

• The model assumes no month-tomonth correlations among asset class returns (correlation is a measure of the degree in which returns are related or dependent upon each other). It does not reflect the average duration of bull and bear markets, which can be longer than those in the modeled scenarios.

• Inflation is assumed to be constant, so variations are not reflected in our calculations.

• The analysis assumes a diversified portfolio, which is rebalanced monthly. Not all asset classes are represented, and other asset classes may be similar or superior to those used.

• Taxes on withdrawals are not taken into account, nor are early withdrawal penalties.

• The analysis models asset classes, not investment products. As a result, the actual experience of an investor in a given investment product (e.g., a mutual fund) may differ from the range of projections generated by the simulation, even if the broad asset allocation of the investment product is similar to the one being modeled. Possible reasons for divergence include, but are not limited to, active management by the manager of the investment product, or the costs, fees, and other expenses associated with the investment product. Active management for any particular investment product—the selection of a portfolio of individual securities that differs from the broad asset classes modeled in this analysis—can lead to the investment product having higher or lower returns than the range of projections in this analysis.

Model Portfolio Construction and Initial Withdrawal Amount:

• The primary asset classes used for this analysis are stocks and bonds. An effectively diversified portfolio theoretically involves all investable asset classes, including stocks, bonds, real estate, foreign investments, commodities, precious metals, currencies, and others. Since it is unlikely that investors will own all of these assets, we selected the ones we believed to be the most appropriate for long-term investors.

• Results of the analysis are driven primarily by the assumed long-term, compound rates of return of each asset class in the scenarios. Our corresponding assumptions, all presented in excess of inflation, are as follows: 4.9% for stocks and 2.23% for bonds.

• Investment expenses in the form of an expense ratio are subtracted from the return assumptions as follows: for stocks, 0.70%; and for bonds, 0.60%. These expenses represent what we believe to be a reasonable approximation of investing in these asset classes through a professionally managed mutual fund or other pooled investment product.

• The modeled asset class scenarios and withdrawal amounts may be calculated at, or result in, a simulation success rate. Simulation success rate is a probability measure and represents the number of times our outcomes succeed (i.e., has at least $1 remaining in the portfolio at the end of retirement).

IMPORTANT: The projections or other information generated by the T. Rowe Price Retirement Income Calculator regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. The charts present only a range of possible outcomes. Actual results will vary with each use and over time, and such results may be better or worse than the simulated scenarios. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations.

The results are not projections but should be used as reasonable estimates.

Source: T. Rowe Price Associates, Inc.