When financial planners run retirement projections for clients, the most common assumption is to assume some type of constant inflation adjusted earnings growth (i.e., annual cost-of-living adjustments [COLAs]). This may seem reasonable enough, as future earnings are highly variable, and many employers do try and offer cost-of-living adjustments to their employees. So why not just assume that will continue throughout one’s career, at least as a baseline?
However, as it turns out, income growth typically follows some predictable paths that don’t necessarily just align with steady (inflation-adjusted) earnings growth; instead, these paths vary significantly based on the general income profile of an individual. For most, income growth throughout their career will actually exceed mere cost-of-living adjustments, which can add up to a lot of additional income (and savings capabilities) over a multi-decade working career! Further, while real income growth is often experienced, real earnings typically peak at least a decade prior to retirement, which is then followed by a subsequent decline in real earnings for the last 10-20 years of one’s career. Which can actually have a substantial impact on the trajectory of retirement savings itself.
In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University – analyzes safe savings rates assuming more realistic earnings growth throughout one’s career, finding that traditional assumptions tend to overstate safe savings rates for low earners and understate safe savings rates for higher earners.
For instance, once we account for more realistic “earnings curves” of workers, it becomes clear that the decline in real earnings over the last 10-20 years of one’s career may actually reduce the retirement need – at least if we assume individuals prefer a smooth transition from pre-retirement to post-retirement spending. As a result, conventional assumptions may actually overstate the required savings rates for all but the top 20% of income earners, while understating the need for top earners (who advisors are most likely to be working with!). Additionally, given that most real earnings growth happens in the first decade or two of one’s career, conventional methods may overstate savings need even further for clients in their 40s or 50s (whose lifestyles aren’t likely actually rising at that point).
Another interesting finding is that once Social Security is incorporated with respect to different earnings curves, it’s possible that low savings rates for many Americans may not be as irrational as is often assumed. In fact, for individuals at the 20th percentile and below (i.e., 1-in-5 Americans), historical safe savings rates may have been as low as 0.3%! And even the median earner would actually “only” need a savings rate of about 6.1%, and earners as high as the 80th percentile would still have a safe savings rate below 10%! Highlighting not only the importance of Social Security to many Americans, but challenging the notion that low savings rates are an indicator of impending retirement doom for many Americans. In other words, this safe savings rate analysis suggests that, when real-world earnings growth is considered, most retirees really will be on track with relatively “modest” savings rates of 10% or less, when supplementing Social Security benefits.
The bottom line is that it’s crucial to recognize that for most workers, simply assuming steady inflation-adjusted earnings growth throughout the working years is not an accurate reflection of reality for most. And earnings curves do matter, because it impacts both the ability to save, when people can afford to save, and the likely level of their pre-retirement lifestyle costs (which in turn will likely impact the cost of the retirement lifestyle they wish to maintain) Of course, there are a lot of contingencies and unknowns when trying to predict earnings curves for any individual, but the fact remains that assuming constant real inflation-adjusted earnings is actually a very problematic default assumption for accumulators saving towards retirement!