Forget About Account Balances – Focus on Income Replacement

We have been coerced into thinking that wealth creation will provide for us in retirement, when in fact we should be focused on how we can create an income stream that will provide us with a meaningful income in retirement.  How many of you (us) focus too much attention on the month-to-month or quarter-to-quarter swings in the account values of our 401(k)s, 403(b)s, etc?

I believe that traditional DC statements need to be enhanced to reflect a projected income stream at various interest rates.  What does a $75,000 balance really mean to a 45-year-old?

Let’s create a profile of an average worker.  The employee is 65 years old, their final salary is $45,000, and they’d like to replace 75% of their final salary on an annual basis in retirement until demise (80 years old).  Social security (average payout) provides $1,294 / month, so we’ll say $15,500 per year.  How much would that individual had to have saved by the time they were a 45-year-old to replace $18,200 / year (($45,000 X .75) – $15,500)?  Well, that really depends on the interest rate (return) that was available to an investor at that time, and whether an annuity has been established that will carry her through to age 80.

For instance, at 45 years old, an account balance of $82,000 invested at 5% will provide upon retirement (age 65) an $18,200 annual income until age 80.  Since the “average” 401(k) balance is somewhere between $80,000 to $90,000, that person is on target.  Right? Perhaps, but maybe not.  Where can that investor get a 5% annuity at this time?  If for instance, they can only get an annuity that has a 3% interest rate, that same investor would need a $134,300 balance at age 45 to collect that same $18,200 / year until age 80.  God forbid rates continue to fall and the annuity is at 1% interest, that 45-year-old needs to have $224,000 accumulated.

So, focusing on the total value of the account and not translating that into an income stream can provide employees with a false sense of security.  We’ve all discussed the negative impact of falling rates.  Retirees and those nearing retirement are forced to save considerably more now than they would have 10-15 years ago, if they expect to replace a decent percentage of their final average salary. 

Finally, if one wants to maintain the purchasing power of their income stream throughout retirement (assuming inflation is at 3%), the account balances at age 45 have to be significantly larger.  In fact, that 45-year-old would have to have $166,100 in their account (and not $134,300) invested at 3% to accomplish their goals.  This balance is significantly greater than the average account today, and dramatically larger than the median account of only $13,000. We have a problem, and the lack of transparency into what our account balances can buy in the form of income isn’t helping.



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