Saving for retirement involves sacrificing something of value today in exchange for something of value in the future. Economists have long argued that this decision is biased in favor of present values because they are more certain than future values, and also closer. The consequence is insufficient savings in the early stages of life, leading to impoverishment later in life.
The compulsory savings scheme administered by Social Security is an important compensation, but it does not cut very deep, and it could depress voluntary private savings by providing a justification for ignoring it. What is needed are programs to encourage private savings. The shortcoming is not the absence of savings instruments, there are many of them, what is lacking is the incentive to use these instruments to save for retirement.
The incentive to save
People are motivated to save when:
- Expected future benefits are known.
- The costs of realizing these benefits are known
- The waiting period until benefits occur is short and known.
For example, many mortgage borrowers save money by making extra payments on their mortgage using a calculator on my website. The calculator is the most visited page on the site, probably because it fulfills the three conditions specified above. It allows the user to specify the future benefit, which is the elimination of mortgage debt within a certain period of time. It shows the exact cost of achieving this benefit, i.e. any additional payment pattern that meets the debt elimination goal. And the waiting period is as long as the borrower wants.
The conditions for saving also exist when consumers plan a specific event at a known time, such as a family wedding or a trip around the world. Compare that with saving for retirement. Most consumers come closest to describing the benefit as “maintaining their lifestyle.” Even if this goal were precisely definable, few have any idea how much they need to save in their income years to achieve it. And of course, they might die before they get there. It’s no surprise that saving for retirement is taking a hit.
Increase the incentive to save for retirement
My experience with the Additional Payment Calculator led me to wonder if it was possible to develop a similar tool, meeting the requirements specified above, that would encourage consumers to increase their total savings for retirement. The answer turned out to be “yes”; my colleague Allan Redstone and I designed such a tool. We call it Retirement Savings (RS). It builds on an earlier program called Retirement Funds Integrator (RFI) which integrates financial asset management, reverse mortgages and annuities.
The end result of RFI is the monthly funds available to the retiree from all sources during the retirement period, plus the value of the estate at any point in the process. RS shows how any savings plan designed by the retiree before retirement affects these outflows. Available funds are a great indicator of retirement benefits, as they will support whatever activity the retiree wishes to pursue when the time comes.
Illustration: A savings plan for a non-wealthy owner
The table below is taken from our new RS. The illustration is of a 40-year-old man who has $100,000 in financial assets, a house worth $400,000 with a mortgage balance of $200,000, and is adopting a savings plan of 500 $ per month, up 2% per year. The chart shows how his initial monthly funds to use in retirement are affected by his savings plan and the addition of a HECM reverse mortgage.
The note on the board shows the wide range of assumptions involved in the calculation. It was calculated using our new Retirement Savings Calculator, which is now on my three websites (see below). The calculator allows anyone to develop a retirement plan based on the characteristics and assumptions that apply to them.
Estate value displayed graphically
The table above has two limitations. First, it shows the initial amount of funds available at retirement, but not the changes that occur in subsequent years. Second, it does not indicate the value of the retiree’s estate. Both are displayed in the time series chart below covering the same retiree characteristics.
The graph shows how the savings plan and the reverse mortgage contribute to the growth of available funds over time, and how the value of the estate is affected by these choices. The savings plan actually increases the value of the estate in the early years, but the reverse mortgage has the opposite effect. Whether this affects the decision of whether or not to include a reverse mortgage in the plan depends on the consumer’s attitude towards the value of the estate.
Manage the plan over time
A retirement plan will almost certainly be affected by changes in financial asset returns, interest rates and other developments during the period between the age at which a savings plan is adopted and the expected age of retirement. To use the plan successfully, the plan needs to be updated periodically, perhaps once a year or whenever the financial landscape undergoes a significant change.
How to start the process
Since a retirement savings plan involves planning for several decades, the plan should be based on the best estimate of how the consumer’s finances will change over that time. As these assumed conditions change, the savings routine can be adjusted as needed and a new retirement plan will emerge.
The mistake to avoid is to delay the start of the process until conditions are more favorable. There are always reasons to delay, today it could be rising inflation and/or the fear of an impending recession. If necessary, the consumer can start a savings plan in which the savings are nominal or even zero for a certain period before they become positive. The key is to start.
Growth in home equity as a component of savings
Consumers who hold a significant portion of their wealth in their home should aim to supplement their periodic savings by increasing the equity in their home during the pre-retirement period. Unless the consumer wants to leave the equity in her property in her estate, this value can be converted into a reverse home equity line of credit to supplement funds available during retirement, as shown in the table and graph. Although the equity in the home on which reverse mortgages are based is influenced by general market trends over which individual retirees have no control, homeowners have discretion over maintenance and improvements that affect the value of their own home.
The key to making the reverse mortgage an effective part of a retirement plan is to gradually introduce systematic line of credit drawdowns into the plan, which is exactly what the example above did. Homeowners who withdraw the maximum amount available from their reverse mortgage at the earliest opportunity are sabotaging their retirement.
Availability and use of the calculator
The retirement savings calculator is accessible to everyone on:
Moreover, in order to speed up the savings process, I have decided to make it available to any financial intermediary who would like to offer it to their clients. There would be no setup fees, and updates based on price changes for annuities and reverse mortgages will also be free.
Third parties accepting this offer, whether they are web-based lead generators, custodians, or consulting firms, will likely find it helpful to maintain up-to-date versions of each projected customer’s account in the future. Custodians in particular could make this a feature of their IRA accounts, where the account holder can monitor the impact of an increase in their account balance on their retirement funds. This will solidify the custodian’s relationship with the client and position themselves to advise on the conversion of a projected retirement plan into an actual plan when the time comes.