Today we have a guest post from Christian Chan, CFA, and Kandarp Acharya, CFA, FRM, portfolio managers of the Wells Fargo Dynamic Target Date Funds.

Few things cause investors more anxiety than saving for retirement. It’s easy to see why. According to CNNMoney’s retirement calculator, I need $940k to retire. Meanwhile, two financial companies’ retirement calculators say I need $1.4 million and $1.6 million. And last week, I read an article quoting members of Congress who’ve found that the Consumer Financial Protection Bureau’s retirement calculator “always displays the wrong amount” because of a coding error. Even in our line of work, target date funds, which are intended to simplify retirement investing, offer drastically different solutions to essentially the same problem. Over a series of blog posts, we’ll try to demystify the topic of retirement savings and provide some insight into how we think about investing for retirement.

At its core, the retirement investing equation is pretty simple. Investors (myself included) typically have some sort of retirement savings plan, such as a 401(k), to which we make monthly contributions. The plan invests our money into some combination of stocks, bonds, and cash vehicles. And after 40 years, or whatever your time horizon might be, the idea is to build a nest egg that allows the retirement we’ve always dreamed of. For some, that dream is having enough money to live comfortably, go on trips with family, perhaps start a second career, or spend a little bit on themselves—perhaps on a vacation to a tropical island somewhere, sipping pina coladas. Others may dream of spending all of their golden years on that tropical island.

So why all the angst? Well, unfortunately, the key variables of the equation above all have some level of uncertainty associated with them. Retirement plan contributions can vary over time, as can stock and bond returns. Some of the uncertainty comes from the market’s fluctuations; each generation of retirement savers has seen volatility in their lifetimes. Not to mention the question of how much do people need in retirement savings to retire comfortably (life can be expensive, not to mention pina coladas!). Let’s tackle each of these questions: contributions, market returns, and targeted retirement savings levels.

Question 1: How much should I contribute to my retirement plan?

In short, you should save as much, as often, and as early as you can. At the very least, if your employer offers a retirement savings contribution match, you should be taking advantage of it. Here’s an example of why saving early is so important.

According to a portfolio model we ran, if you contribute $2,000 to your retirement savings every year from age 25 to age 65 (for a total contribution of $82,000), you could amass an expected retirement savings amount of $403,000 at age 65. Our model assumes a consistent 6.75% annual return (not counting fees), with all contributions occurring at the beginning of each year. For a $2,000 a year contribution, that’s not bad!

But consider this: If you could scrape up an extra thousand bucks a year for the first 10 years of your savings timeline (in other words, contribute $3,000 per year from age 25 to 35) and then reduce your contributions by $1,000 during the last 10 years (contributing only $1,000 per year from age 55 to 65), your total contributions would amount to the same ($82,000), but the expected value of your total retirement savings would be $493,000. Based on this model, you could gain an extra $90,000 in retirement savings by saving more when you’re younger.

The reason for this is pretty simple. Portfolio returns compound over time. A 5% return on an asset base of $1,000 generates $50, whereas a 5% return on a $100 asset base generates only $5. So the larger your asset base, the more in retirement savings you can generate with a given level of return. So if you want to maximize your retirement savings, save early and save often!

Question 2: What should I expect from the stock market?

In case you haven’t noticed, the stock market moves around. In fact, it moves around a lot. In January alone, the price of the S&P 500 Index ranged from 2,038 to 1,812—that’s an 11% decline within one month. Thankfully, retirement investing does not take place over a one-month time horizon. In fact, the longer your time horizon, the less uncertainty you can expect over that time horizon. The chart below shows the range of equity market returns (as measured by the S&P 500 Index1) over various time horizons.

The stock market's range of returns over various time horizons

While the median returns for all time horizons shown on the chart are pretty similar, the range of historical returns varies tremendously. For example, over 1-year time horizons, we have seen historical returns anywhere from -50% to +61%, but for 20-year time horizons, the range of returns has been much narrower, ranging from to +7% to +18%. So over long time horizons, market returns can be a lot more predictable. The reason for this is mean reversion. Like a lot of things (predicting the weather, coin flips, etc.), the markets tend to revert to some sort of long-term average if your time horizon is long enough. For retirement investors, who—depending on when they begin saving—often have time horizons of 20 years or longer, investing in a portfolio that includes equities can be a pretty effective strategy. And by the way, the 11% decline in the S&P 500 Index we saw in January? Stocks in that index are now up 10% from the January low and a stone’s throw away from 2,000.

The way ahead: Maximizing your savings over the long term

As the recent stretch of market volatility has shown us, saving for retirement isn’t easy, and the anxiety and confusion people sometimes feel is perfectly natural. That being said, there are things we can do to ensure we’re making the most out of our savings and the markets. Building a contribution game plan that works for you and keeping a long-term perspective toward the market’s ups and downs are two ways to help achieve your goals. In our next blog post, we’ll take a look at the important role of asset allocation in retirement savings and discuss issues and possible solutions for tackling retirement savings shortfalls.

1 Source: Ibbotson data from 1926 to 2015; nominal returns, gross of fees. Returns for periods more than one year are geometric averages.

0
0

You might also like: