Executive Summary
As the baby boomers move inexorably closer to retirement, many have lamented the plight of the generation, which appears to have dramatically undersaved and therefore is ill prepared for retirement.
Yet the reality is that given how spending fluctuates through the working years - especially when raising a family - it may be entirely normal for couples to save less during the bulk of their working years, and instead save substantially in just the final years before retirement when the cost of raising children winds down. In turn, savings in the early years can actually be less effective than reinvesting into the individual's "human capital" and increasing lifetime earnings. And in such an environment, the real issue is not effectively saving in the early years, but instead is to proactively manage spending to ensure it does not ramp up too rapidly in the later years.
Combined together, this suggests that the reality may be that back-loading retirement savings into the final years before retirement doesn't mean baby boomers are "behind" but instead that they have been following a remarkably normal and even "optimal" path!
The inspiration for this week's blog post is a continuation of last week's discussion about how just saving a percentage of income each year may be ineffective advice, because in reality with a real increase in income and a stable spending level, the savings rate should rise significantly in later years. Yet retirement saving shouldn't rise in later years just because income increases faster than spending; couples who raise families may also find that retirement savings is constrained in early years due to the impact of paying for children and saving for college. As a result, the reality is that for clients with rising incomes and raising families, it may be entirely normal for the bulk of retirement savings to occur in a relatively limited number of years right before retirement - which in point of fact, is the exact plight of most baby boomers today!
Traditional Planning For Saving And Spending
In the traditional accumulation planning approach, clients and planners focus on income, and then allocate the income to various categories, including saving and spending. The challenge, however, is that as personal circumstances change over time - e.g., as children are born, age, and leave the house, income goes through fluctuations, needs change, etc. - trying to maintain a stable saving pattern in the face of fluctuating needs leads to volatile spending patterns.
For instance, if the couple earns $100,000/year and seeks to save 20% (or $20,000) of income, and owes another 20% for taxes, the couple only has $60,000/year (or $5,000/month) remaining for personal consumption. If a child is born that requires additional ongoing expenses, not to mention additional college savings, the family is forced to reduce their $60,000/year spending to adjust, constraining their lifestyle.
Spending And Saving - Ideal Versus Reality
Of course, in reality the adjustment where the family curtails its other spending to accommodate new children or household expenses while maintaining savings rarely happens. Instead, expenses ramp up with the addition of a child to the family, and in turn the family's total spending rises, carving away a portion of the amounts previously being saved.
The end result - expenses rise, savings decline, and the family struggles to find enough money at the end of the month to support their savings goals. Then at some point in the future, when the children eventually leave the home (and/or finally graduate from college), family expenses decline as the couple reverts to their prior 2-person household, allowing for greater room for savings. If income has grown by a real rate of return above inflation, savings in the later years may ramp up even further.
In other words, the ideal where clients save steadily every year simply may not be realistic planning.
Smooth Savings Versus A Focus On Consumption
What the above example illustrates is that while financial planning often advocates a smooth and steady savings path - and let spending adjust as it must - in reality most people have uneven spending and let the savings adjust as it must.
However, this doesn't necessarily have to be problematic. After all, if the reality is that spending is uneven as people raise families, and furthermore that it's more productive to invest in one's career in the early years to reap the real income increases down the road, then in fact most people should end out consuming the majority of their income for the first half of their working years... until they finally reach that combination of peak earnings years and the decline in spending that accompanies children leaving the house, allowing for a transition to significant saving in the home stretch to retirement.
Notably, then, the key to making the consumption-centric approach work is to keep spending at reasonable levels throughout the time horizon - especially when other family/children/education expenses decline in the later years. If "temporarily" higher spending on family, children, and education is replaced by savings, it becomes remarkably easy to catch up; if the spending simply shifts to other spending, though, the savings rate never rises enough and the couple ends out behind on retirement.
Financial Planning Implications
If we assume that in fact an uneven lifetime spending pattern is the normal reality for most people - which makes a level spending approach impractical or outright impossible - then many traditional financial planning implications shift.
For instance, the reality may be that baby boomers that have little saved for retirement are in fact not behind, but merely right on track, positioned to capitalize on their empty nests and peak earnings years to save substantial sums of money to close the retirement savings gap.
In turn, this implies that the focal point for advice through most of the working years should not be on saving and investing at all, but instead on further growing future earnings (which may actually involve not saving in retirement accounts but instead investing in human capital), and on maintaining a steady lifestyle so that excess income can be allocated to savings as received. In this framework, the reality is that baby boomers that are behind may not be in trouble because they failed to save in their early years, but instead simply because they allowed their spending to ramp up too much in the later years.
But the bottom line is that the traditional approach - advocating a steady savings rate every year from the beginning of the working years to the end - may be both unrealistic given the unsteady nature of consumption throughout life, unnecessary for those whose income grows in excess of inflation over time, and suboptimal for those who could more effectively reinvest early savings into growing their human capital instead of their financial capital.
So what do you think? Have we been too focused on saving in the early working years? Is the reality that baby boomers have simply been following the normal progression, where savings is loaded into the later years when family expenses decline and earnings peak? Does the focus need to shift from steady savings to a steadier path of spending?
(This article was featured in the Carnival of Personal Finance #378 hosted on NerdWallet.)
This article presents a really good and unique perspective. Thanks for writing it. Made me really think of my own personal situation as someone with a young family who drives my wife crazy with wanting to save, save, save. Seems she may be right and I, the planner, wrong (gasp).
You also present a strong case here for not increasing your standard of living (at least not too much!) during peak earning years.
Of course there’s something to be said for learning how to invest sooner than later. It can take many years of fits and starts to develop an investment philosophy that will serve one well during the years from middle age through retirement and beyond.
Steve,
Quite true, and I think there’s a lot to be said for the education and experience gained by investing when younger.
However, I suspect a lot of those ‘educational’ goals could actually be accomplished with quite modest sums, and not necessarily the perhaps-too-high savings bar that we set for a lot of young earners today.
– Michael
I certainly agree with the prior comments. However I am also concerned that waiting to backload savings means that the later years can be subject to unemployment, medical issues, unexpected family dynamics, and much more – thereby significantly reducing the reality of being able to make up for putting saving on the backburner earlier, regardless of how important the rationale seemed at the time. The story of the grasshopper and the ant comes to mind…..with the eternal caveat of ‘balance’, of course. Laurie
We’ve always advised clients to implement a plan that funds retirement first, then funds college costs for children to the extent possible (choosing a less expensive school, taking out student loans, etc., would make up any deficit in the parents ability to fund the costs). With the strategy you outline, how would planning to meet those two goals (retirement and education) be coordinated so that funding college does not exceed a financially healthy level just because it is first on the timeline? I also share the concerns of Laurie’s post regarding the risk of counting on secure employment, good health, etc., in later years to fund the bulk of the retirement savings. Thank you for continually challenging us to think in different ways. -Garnet
I appreciate the perspective and point that baby boomers today may not be in too bad of shape if they can save heavily now. However, I think it’s a huge assumption that people will save heavily once their expenses decrease. The folks I talk to in their 50s are anxious to spend that money on themselves after a life of raising family. I think the advice to save from an early age creates a discipline that would allow saving more later. But without that discipline established I would not be comfortable recommending a client delay saving until later in life.
Good point about people in their 50’s spending more as earnings peak. My experience has been that some do spend more but others generally maintain their standard of living.
I have quite a few clients who saved the lion’s share of their retirement savings in just several years, just as Michael suggests happens. Of course, they were disciplined and had decent savings to begin with (and good incomes).
But, as you mentioned, I have also seen folks suffer lifestyle inflation as their income rises. I think a lot of it has to do with decisions made about housing. In my experience, many client’s who bought bigger (or just more expensive) homes in their late 50’s did not have as much ability to grow retirement savings. Those who maintained relatively affordable housing costs did pretty well.
In many places, workers in their 50s are the first to go in a layoff, and it is very hard for these people to get back a job with similar pay. This is especially true in the tech sector, where most jobs are filled by younger employees and very few older employees have what it takes to get promoted.
Lily,
Indeed, earnings income can have some instability too.
But in practice, this partially makes my point – because we spend too much time talking about saving, and not enough time talking about SPENDING, most people ratchet up their lifestyle to keep pace with their current earnings. As a result, when a pullback in income occurs in their 50s, there’s a crisis.
Particularly in professional services jobs, a lot of people I’ve seen would have ample income, even after a pay cut, if they hadn’t ramped their spending up to their peak income in the first place. If they were still living a standard of living closer to what they had in their 30s with only a modest increase, and were banking the majority of the income increases, they would be in a far better place.
We need to spend less time talking about saving alone, and a lot more time focusing on responsible spending.
Respectfully,
– Michael
Wow! That was a dangerous article! To present as a viable option for retirement saving to miss years of the magic of compounding interest by “stockpiling” savings only in later years is poor advice. Of course many people find themselves low on the saving tree for both valid and not-so-valid reasons, so yea, “stockpile” all the savings you can.
But it is a disservice to equate the result of a long-term saving effort with the idea of, “aww, we can catch up later”. Some people are going to love your article…..to bad for them.
David,
Dangerous, or more realistic?
Given the incredible number of baby boomers who have been incapable of following the “traditional” advice of saving more early – precisely because it ignores the realities of lifetime spending – perhaps we need to re-evaluate the effectiveness of the advice?
More generally, you seem to focus on the compounding of assets without acknowledging the compounding of income, and you might note that in this and the previous article linked here, I emphasized heavily the importance of managing and moderating spending.
The point is not “don’t save”. The point is “increase your spending by less than your income rises, and you’ll end out with a whole lot more money anyway.”
– Michael
My experience with family, friends and clients would indicate the traditional approach as still the best approach.
People should aim for the periodic savings approach regardless of situation. Most importantly, this negates the tendancy people have when coming into extra money at the end of the month to — how shall I say — PAR-TAY!!! The rigors of savings oftimes takes a back seat to wants, so ritual savings before you can spend it is still a good idea. And should you have a really, really good month, then do some partying.
The other aspect to relying on ehd of career loading is that, having saved nil during the early career/family years, one may find a downturn in the later years with a matching downturn in cash flow. The person just doesn’t have enough time left before retirement to dig out.
Naturally, if you have tons of dough, this may not be needed but for the majority of low and moderate income/net worth families, it should save a lot of sorrow as they approach the golden years.
I agree with you, Michael. I believe you and Wade showed that the bulk of retirement portfolio balance comes from market returns in that last decade or so before retirement and not from additional savings. So, Boomers would be right on track IF the market complies. Then again, a lot of people WERE on track early in 2007. So, save more, save less, it doesn’t matter if stocks don’t move your way.
Just because the greatest success factor in saving likely will be market returns the decade before you retire and second may be how much you save those last ten years doesn’t mean you are discouraging people from saving early in life, just that it’s less effective.
Didn’t you guys also say it’s extremely difficult to even know if you’re on track? So, hasn’t your writing shown that the answer to your title question is “It’s very hard to know?”