People don’t realize what a huge impact it has when we add investment returns to our savings over a lifetime, or how important it is to keep the investment effort going after retirement. In this post we’ll look at some numbers and come up with a simple rule of thumb.
We know that it’s not unreasonable to expect a higher return (the so-called “risk premium”) if we take higher risk. In this post I want to give you a rough idea of how much our lifetime savings can be multiplied if the risk premium that we hope for, comes through.
From our book The Retirement Plan Solution published some years ago, we three co-authors found out that the most memorable take-away was what we called the 10-30-60 rule. Based on assumptions that seemed reasonable before the global financial crisis, we estimated that, if an individual saved over a lifetime (specifically, from age 25 to 65) and gradually drew down the pension pot in retirement (specifically, from age 65 to 90), roughly 10 cents of every dollar of post-retirement withdrawals came from money that was saved each year, roughly 30 cents came from investment returns in the pre-retirement accumulation period, and roughly 60 cents came from investment returns in the post-retirement decumulation period.
Let’s be explicit about interpreting two aspects of that result.
The first is that, if 10 cents saved ultimately creates a dollar of withdrawals, overall that’s a multiplier effect that gives the original savings 10 times as much power by investing them.
The second is that the aggregate investment return after retirement contributes twice as much as the aggregate return before retirement: 60 cents versus 30 cents.
No wonder people found those conclusions memorable!
Of course it’s possible to quibble about every one of our inputs. You wouldn’t expect to earn the same return today, with governments deliberately holding down interest rates. You wouldn’t take as much investment risk in the drawdown period as you might in the accumulation period. Who knows what the individual’s pay path would look like? Or life expectancy. True, true, true, true.
So there’s a simple challenge to any critic. Put in your own assumptions. If you re-do the calculations, two conclusions will still emerge:
- Investment returns create a huge lifetime multiplier effect on the amounts actually set aside as retirement savings. (It doesn’t matter whether or not the multiplier is 10.)
- A large proportion of the overall investment return actually accrues after retirement. (It doesn’t matter whether or not it’s twice as large as the amount that accrues before retirement.)
You may think the investment job is done once you retire. It isn’t. There’s probably at least as much to be done after retirement as there was before.
Just for fun, the table below shows the numbers (underlying 10-30-60, that is), based on a first year contribution of 1,000, and aggregated into 5-year periods.
- The contributions grow gradually, as the pay increases gradually.
- The investment return starts off small. It takes more than 10 years before the returns exceed the contributions.
- But after that the investment returns accelerate noticeably. This is often called “the magic of compound interest.”
- After retirement, withdrawals start.
- Even after withdrawals start, the investment return on the remaining assets is large for a long time. That’s because the assets remaining stay large. This is why the aggregate post-retirement investment return is so big – and so important.
The Multiplier Effect
|Partici-pant’s Age at Start of Year||Accumulated Assets at Start of 5-Year Period||Total 5-Year Contributions Made (increasing at 4.75% a year)||Total 5-Year Withdrawals (increasing at 3% a year)||Total 5-Year Investment Return (at 7.5% a year)
lated Assets at End of 5-Year Period
By the end, of the 1,057,950 withdrawn, only 113,680 (between 10% and 11%) came from contributions and 944,270 (between 89% and 90%) came from investment returns. If you do the addition, of the investment returns 325,637 (just under 31% of the withdrawals) accrued before retirement and 618,633 (a bit more than 58% of the withdrawals) accrued after retirement.
To remember it conveniently, we called it 10-30-60.
The main lesson is simple. The investment job is less than half done at retirement.
Over time, investment returns multiply our savings enormously. And much of that effect takes place after retirement, so continuing to focus on our investments after retirement is vital.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.