The standard tribute to saving for retirement is to purchase a kind of financial instrument called a savings. The idea is that individuals consume during retirement, and out of their earnings – their income during their working lives – they save enough money to retire. This would typically refer to the purchase of bonds or stocks, with the expectation that the value of these assets will increase and thereby provide the funds for retirement. The part about “building up” a nest egg is taken quite literally, as households do not purchase the structure in which they will house themselves during their working lives. Indeed, a used bird’s nest is quite literal here because saving for retirement would be averted if workers’ output during their working lives is sufficient to both compensate them for the goods and services they consume during their lives and an efficient amount of output that can be traded to older workers.
Everyone has heard it said that it is important to save. There is little disagreement on this point. After all, we know that we need to save in order to be able to consume in the future. What does change across individuals, however, is how successful we are in implementing this advice. The need to save for retirement is an obvious example of how hard it can be to save. In contrast to other outcomes, such as college attendance, where the benefits of saving are observed relatively quickly, the benefits from saving for retirement are far in the future. As such, the future benefits may not just be unseen, but also unsought. It is within this empirical fact that our research on retirement savings is based. The central research question is why it is that people save such a small share of their income for retirement. Our goal here is to describe the types of answers that have been posited, the evidence provided in their support, and some of the cross-cutting themes that have emerged from the literature.
The effect of taxes and Social Security contributions on savings needs to retire is also examined. This examination illustrates the benefit of a before-tax contribution plan arrangement. It also shows how Social Security, whose benefits are formulated in a progressive manner, can put less financial strain on lower retention-income cohorts. By allowing individuals to effectively quantify the retirement income benefit of participating in a company plan, firms can pass on a useful tool so that employees may project retirement readiness and adjust their saving and personal financial goals in order to achieve their desired lifestyles upon retirement.
Saving for retirement is a primary goal of many financial plans. However, some people may not have a clear understanding of the benefit of saving or the importance of starting to save early in their careers. This study uses a simulation tool to analyze the amount individuals need to save in their retirement plan based on their annual salary and the number of years they expect to participate in the plan and receive an employer match. In addition, the study shows the financial benefits an individual receives by saving via both before-tax and after-tax deduction arrangements. Individuals who put off retirement savings, particularly when participating in a retirement plan with a defined benefit payout, may not fully appreciate the cumulative benefit of saving over a long tenure.
Current Retirement Trends
Many factors determine when people retire, including legislation, funding and other compensation plans, as well as age. In the recent past, a strong stock market, which led to good investment returns and high profits, often encouraged earlier retirement, as employees saw their stock portfolios and company plan distributions grow. Large layoffs and downsizings in the early 1980s also led, at least partially, to a not-too-subtle push for more people to retire. However, legislation has had the most significant near-term impact on this equation, especially in the United States. Incentives to retire remain varied. Some incentives are schedule neutral – a certain payment is made as a lump sum regardless of when the individual retires. Other incentives, such as the employer and full retirement age benefit schedule, penalize those who retire before certain scheduled dates, as opposed to providing a pay increase for those who retire after a certain date. Some offer no early retirement or late penalties. However, while retirees may have costs paid, sometimes the worker side also has to pay. Some policies are not clear, as late-retirement incentives may be hard to identify because they are sometimes (although not always) more subtle, such as the result of representations in early retirement materials that promise the full amount when it is scheduled to be paid, regardless of the actual payment schedule, or the elimination of certain benefits.
The United States and other developed nations have seen dramatic changes in the nature of retirement over the years, mainly the result of increasing life expectancies and the historic shift from predominantly agricultural to urban-based industrial economies. As more people moved to urban centers, government and industry began to look for ways to pay for those no longer working. The end result was retirement at a relatively young age and poorly funded retirement systems. During the past 50 years, this scenario has continued to play out, and Western nations are witnessing an equally dramatic shift in policies in order to avoid the occurrence of what academic and policy leaders refer to as “crises” in social security systems.
Factors Affecting Retirement Savings
Changes over the life cycle in earning abilities and opportunities as well as in other household characteristics can be expected to influence retirement saving, partly through the way tax incentives are designed. Earnings needs over the life cycle – considered to be more or less encompassed by the sum of permanent income plus total household wealth (theoretical precautionary saving) – are one motive for saving in tax-favored accounts. As people age, these earnings needs diminish in the eyes of economic theory, reducing the need to hold wealth in tax-deferred accounts and, at the conceptual least, maintaining some sum of liquid wealth on which to retire.
Many factors may explain why people save different amounts for retirement, although the roles of these factors are incompletely understood and undoubtedly interrelated. A central role is played by changes over the life cycle in earnings, household composition, and precautionary saving needs, together with the tax incentives and spending pressures that lower the cost of contributing to retirement saving plans. The demographic structure of the workforce determined by past and current birth rates, death rates, immigration rates, and age-specific labor force participation rates also influences the amount of saving channeled into pension plans. Institutional arrangements govern how saving in pension accumulations is presented to workers, and especially the form of pension benefit promises and benefit preferences.
Income Level
Note that we make no pretense of this methodology providing an unbiased or even consistent estimate of this problem. Nonetheless, it should give us a rough idea of the possible significance and direction of the problem. What is of interest to me is: do we have a sample selection problem – i.e. is there reason to be concerned? Existing patterns in the data, i.e. are those who are observed saving doing so in a manner predicted by the native pension estimator – who benefits and who doesn’t? More sophisticated ways to use these two models to generate new information (e.g. a particular attribute regressed onto PENSIONPED) are left for a later project.
The model is initially estimated for different income quartiles (of the native pension model). The results show basically the expected signs – those who earn less are expected to save less, all else constant. We then use the model to simulate the derived (i.e. expected) saving rates for the unrestricted data across the quartiles (since it is likely that the parameters for those who are saving, and the error properties are drawn from the sample). If the saving rates observed in the external data are significantly different from those that are derived from the native model estimates, looking at the distribution of wealth and the parameters across the two datasets provides us with a way to informally check if the sample is selected for having more or less of the pension saving attribute. In other words, do we have a sample selection problem?
Age and Life Stage
Saving is a decision that occurs in all parts of the life cycle, but the importance and nature of that decision changes over a person’s life. Most people with a job begin their life cycle of saving in their late teens or early twenties, with savings beginning when they hold their first summer job. Unfortunately, because there is no explicit separation of retirement saving from saving for immediate consumption needs in our retirement database, it is difficult to determine the amount of saving that goes into accounts explicitly earmarked for retirement.
Income plays a large role in retirement planning, as it affects the amount people are able to save, their ability to access certain types of retirement plans, and the benefits they can expect to receive from Social Security and other components of the retirement system. However, retirement decisions are also critically affected by the stage of life that individuals and families are in. In this section, we begin by discussing the importance of life stage in the context of saving, with a particular focus on the relationship between saving and age.
Strategies for Effective Retirement Saving
An urge you can give in your first decades of saving is to commit to spending any wage increases on increased saving. That way, you won’t ever miss the money you put away for retirement. In fact, this commitment to increased saving is a particularly effective strategy when you are young. Not only is the compounding of long-term saving most valuable, but also, in your younger years, the relative increase in your assets accumulated by saving the extra dollars is the greatest. You may be surprised to learn how fast the routine of increased saving can grow. For example, suppose you start saving 10 percent of your $40,000 salary or wage, which comes to $333 a month. Then, suppose you receive a 5 percent increase in your pay, which adds another $167 to your rate of saving for the year. You will have increased the stock of your assets devoted to saving by almost 50 percent in just one year. The second year will be even better because you will receive a full year’s worth of additional saving in addition to the saving already in the bank. Based on that, we believe to have shown that, as long as you save regularly and put your money to work in reasonably diversified investments, you can grow ahead of inflation by holding financial assets for many years.
First, we note that, by and large, the most effective retirement-saving strategy is to commit now to saving systematically, year after year. By doing so, you get the full benefits of long-term compounding, and you don’t worry at all about market timing—a notoriously futile and typically costly endeavor. In general, we believe that when people take a long-term perspective on retirement saving, they are likely to come up with a plan that emphasizes consistent saving. Of course, that may require making some sacrifices now. As we have noted earlier, in all the analysis we present in this book, we assume that people maintain their systematic saving plan, even in the face of short-term ups and downs in the market. That often-severe test can mean postponing consumption for a different and generally better time in your life. Nonetheless, we found in Chapter 3 that many people don’t save any money in retirement accounts, often because they are in financial difficulty.
Setting Realistic Goals
So, how much do you need to save? The first thing you need to do to develop a plan is to determine the following: 1. In what age bracket are you now (in other words, how many years do you have until you retire)? 2. How much money do you have now? 3. How much money will you receive each month from government programs: social security, etc.? 4. What is your annual salary? 5. How much do you spend each month? After you retire, your spending will change, so also estimate how much you will spend after retirement.
We now know that we need to save for retirement and how much we might need to save. Be prepared, however; the sum of money required will probably still startle you. The question then becomes: how do you get there? You need a plan. You need a way to make a large, seemingly unattainable amount of wealth become achievable. The good news is that it is possible to accumulate a very substantial amount of wealth given time and the miracle of compound interest. The bad news is that you need a reasonable plan. You can’t expect to earn 25% per year, year after year. You can expect to earn about 3-4% per year over a long period. You can’t expect to save $10 and become wealthy. However, if you can save about 10-15% of your salary for 35-40 years, you will accumulate a very substantial sum of money.
Utilizing Retirement Accounts
Incentives to save abound. All these accounts offer tax deductions for amounts contributed to the retirement account (pretax income is lower than it would be otherwise). Tax deferred compounding of those amounts placed in the account and all realized earnings until withdrawal make up the next saving bonus. It’s power of tax-free growth in the account that generates significant relief. The postponed payment of taxes owed on the earnings on savings (compounding effect) is powerful stuff. If a person withdraws the earnings after 5 years (without penalty) and at age 59 1/2 (minimum distribution traces age 70 1/2), the income tax due equals zero. At the 28% federal marginal tax rate on investments, under a 25 year invested scenario, 48% higher account balance could be achieved. Compound on the entire amount, and that is significant additional capital to optimize a comfortable retirement.
Which types of accounts are best to use for saving for retirement? One could argue that all accounts can play a role in retirement. However, to maximize savings and meet someone’s spending goal in retirement, the optimal retirement savings wagons to climb aboard are the tax-deferred retirement accounts, which include the tax-deferred employer-sponsored pension and savings plans, individual retirement accounts (IRAs), myRA, 401(k) and 403(b) plans or the Roth (or post-tax) retirement savings accounts.
We have seen how expensive retirement can be and how difficult retirement planning is. We have seen how making trade-offs later may result in some difficult decisions and severe hardships at older ages. We have seen how important it is for American families to start saving for retirement today. Efforts have been made by public authorities to attempt to improve the level of retirement savings. None of them has persuaded a sufficient number of persons at risk to save enough. Therefore, we must try substantially different approaches or adapt current approaches to current economic, demographic, and financial market developments. In any event, the private sector should participate in any changes. The federal role should be to ensure that the public and private sectors are contributing to closing the retirement saving gap.
There are many benefits of increasing our retirement account contributions. More compensation increases your future retirement benefit. Allows a tax advantage for money invested by purchasing the runs. Administrator the plan manages your monies well by providing good investment responses and generating higher bandwidths. You can acquire a lifetime income, which gives you an annuity in retirement so you cannot outlive your funds. Save through an employer-sponsored retirement savings plan such as a 401(k). An employer-sponsored retirement savings plan provides a number of tax advantages, including the deferral of federal and state income tax on any contributions and investment earnings. These accounts also provide time and convenience. Contribution percentages are often elected before your salary earnings are paid, making saving automatic every payday. On the day you register for the plan, your employer withholds the contribution from your paycheck. You can save in a tax-deferred account by stockpiling an uncertainty account, such as a 401(k) or individual retirement account. Making before-tax contributions to a tax-advantaged account can help you lower your taxable income and your progress at the same time.
Start saving for retirement as soon as you are able. When you are young, time is on your side. The longer you invest, the less you have to invest to end up with the same amount of money for retirement. Contribute to a retirement account at work. Take advantage of money available today in your paycheck. Save in other tax-favored accounts and in regular taxable accounts. Diversify your investments to spread the risk in your portfolio. Don’t have your investments in the same type of assets. Earn more by taking responsibilities. Start to work up the professional ladder by gaining experience and earning increased verse over time. Increase your investments of earnings in your retirement account. Use compounding to build your retirement savings account.