It’s the year 2060 and you’re about to celebrate your 65th or 70th birthday; you’re feeling excited because this is the year you officially retire. Then you do the math on your 401(k). You have the equivalent to give yourself a $649 monthly paycheck for your remaining years.
Unfortunately, that is the scenario too many Americans are facing. The average retirement savings for people between the ages of 65 to 74 today is $148,000. That fact, coupled with expanding life expectancies, has caused a growing number of economists to warn of a coming retirement crisis in the United States.
While that might be the collective situation across the United States, that does not have to—and probably will not—be the case for you if you take action while you’re still in your 20s and 30s.
To get a better understanding of retirement economics and what it means for young professionals, we spoke with Charles Ellis, the founder of Greenwich Associates, a former board member of the Vanguard Group, and the co-author of Falling Short: The Coming Retirement Crisis.
Ellis says the state of American retirement is more nuanced than previously understood and there are several ways we, both as individuals and as a society, can save ourselves from a full-blown retirement crisis.
Earnest: We see headlines every day about the looming retirement crisis. What are some reasons behind this?
Charles Ellis: While 401(k) plans have come to dominate the retirement landscape for working professionals today, they were never intended to be the primary retirement vehicle for American workers. In fact, the 401(k) model leaves critical decisions for individual employees to work through:
- How much to save each year
- Which asset classes and funds to use
- How to adjust their asset allocation over time
- How much to withdraw each year during retirement.
Unfortunately, many employees—especially those who are just starting out on their first or second professional job—are not adequately prepared to navigate these questions successfully. This could mean they will be stunned to see how little they will have to live on during retirement when the time comes.
How can someone at the beginning of their career get started for retirement planning?
The first thing is simply to have awareness about saving and retirement planning. For young professionals, the key financial priorities should generally be to:
- Establish an emergency fund and build towards having three to six months of living expenses on hand
- Get your debt under control by paying off any credit card balances and refinancing your student loans if you can
- Begin investing for retirement through a 401(k)
What makes this challenging is that you may also be paying down student loans, saving up to get married, start a family, or buy a house, all while getting your career established. In other words, you will make a lot of important financial decisions in your 20s and 30s!
However, for retirement, remember that your 401(k) is the best tax-sheltered investment opportunity available. You should invest as much as you possibly can—the annual limit is $18,000 for people under age 50—especially if your employer matches your contribution.
How would you recommend younger workers invest in their 401(k)?
Younger workers should generally invest most of their money in a diversified portfolio of stocks. Low-cost funds are important and index funds are generally your best bet. These are often available in the investment offerings in your 401(k).
Many 401(k) plans offer target-date or lifecycle funds—each of these funds is really a diversified portfolio designed so that it’s level of stocks and bonds adjust over time as you get closer to retirement. This is an easy choice if you want to pick one thing and not have to worry about it.
Younger workers have a longer life expectancy and working career in front of them than prior generations, so they have a longer investment horizon which makes stocks a superior investment versus bonds. Stocks will have some ups and downs but are the best long-term asset class.
After that, it is a matter of what I call benign neglect. As long as you are contributing regularly to your retirement accounts, the less you look at your statements and balances, the better. Keep your focus on the long-term and do not sweat market volatility.
What’s the best way to balance paying student loans vs. building towards retirement?
This is an important issue. My co-author, Alicia Munnell, who is the head of the Center for Retirement Research at Boston College has found some evidence that the explosion in student loan debt is exacerbating the retirement crisis. For the individual, it is a tradeoff where you have to decide how to allocate your income across your personal financial goals.
As I mentioned, establishing an emergency fund is really important and Americans generally are not adequately prepared for emergencies.
After that, I would focus getting your household debt into a good place. This means paying down any credit card balances because they tend to carry the highest interest rates. Then look at any other debt you may have, like student loans or auto loans, and whether you can consolidate and refinance to lower rates.
Check our student loan calculator to compare your rates.
Once you have an emergency fund and more manageable debt with lower interest rates, then you can really focus on investing for your future.
What makes investing in your 20s so different than later in your life?
A good way to appreciate the importance of investing early is a shortcut called the Rule of 72. If you divide 72 by your expected investment rate of return it will give you an estimate of how many years it will take you to double your money.
For example, if you can get a 6% rate of return on your investments it will take you about 12 years to double your money (72/6=12). At a 10% rate of return, it will take you closer to 7 years to double your money.
As a starting point, think about not spending $5 on a coffee at a Starbucks tomorrow or beer after work, you save and invest that instead. At 7% return, your $5 would double in 10 years and again in 10 and again in 10 and again in 10, you would have $80 in 40 years when you might actually need it.
Imagine what you could do if you did this every day. If you saved and invested $5 a day every day for 30 years you could have more than $180,000 (assuming a constant 7% return)—just for making your coffee, instead of buying it.
“Time is the great advantage for young investors and compounding is a powerful tool.”
Time is the great advantage for young investors and compounding is a powerful tool. Put the two together and big nice things happen for the young saver: she makes money with money night and day.
What can we do as a nation to work our way out of the looming retirement crisis?
We provide a more comprehensive list of policy ideas in Falling Short, but let me touch on a few important areas here.
Currently, workers can claim Social Security benefits any time between ages 62 and 70. While benefits claimed before 70 are reduced, most workers do not understand how much they can increase their benefits by waiting to claim them. Right now, the message is that your early 60s are the right age to retire. However, Social Security benefits claimed at age 70 are 76% higher than benefits claimed at 62—and those benefits are also inflation protected and last as long as you live so there’s no mortality risk. Making 70 the recommended and default age to claim Social Security would go a long way to improving the retirement picture for most workers.
Then we need to improve 401(k) programs. This includes ways to improve participation rates and contribution levels by using thoughtful default program mechanisms. For example, 401(k) plans with opt-out features see approximately twice the participation rates as opt-in programs that require the employee to take the initiative to sign up. The 401(k) industry also needs to continue moving towards lower-cost funds and easier to use, diversified offerings like target-date funds.