Some arithmetic on retirement income
I’ve been thinking about the impact of the financial crisis on retirement income policy and individual strategies, and have come up with a reasonably simple way (I hope) to illustrate the core problem. Pre-crisis, it seemed reasonable to base a retirement strategy on the idea that a long-term investor, focusing on stocks could average a 7 per cent real return over 30 years, with relatively little risk. Now it’s clear that assumption has been proved wrong for lots of people. So it seems reasonable to ask how retirement strategy would look if, instead, you assumed a 2 per cent real return (what you might get with a portfolio of government bonds and the safest stocks).
To answer this question, we can use the magic of compound interest. At 7 per cent, money doubles in 10 years (the rule of 70), so a dollar invested today will be worth 8 dollars in thirty years time. That means someone with a stable real income, who starts saving 10 per cent of their income at age 25 and retires 30 years later at age 55, with a further life expectation of 30 years, can retire on 80 per cent of their pre-retirement income, as compared to 90 per cent net of saving in the working years. Quite attractive!
At 2 per cent, though, money doubles in 35 years. To get a more less stable consumption stream you need to change the balance above by a factor of four. A simple way to do this is to double contributions, to 20 per cent of income and shift the work-retirement balance, so that you work from 25 to 65 to finance an expected 20 years of retirement income.
Among other things, this means that the flow of savings into superannuation will have to increase a lot in the medium term which may help to resolve some of our many macroeconomic imbalances. But how this is to be brought about remains to be seen.