Does It Ever Make Sense to Stop Saving For Retirement?

This Knowledge Center post was adapted from Wealthfront COO Adam Nash’s answer to a question on Quora — Ed.

The Question: Let’s say I’m 30 and have $250K in my 401k. If I stopped contributing now I would have $2.5M in my account by the time I’m 60 and am allowed to make a withdrawal. That should be enough right? Even if it isn’t, there must be some point where it makes sense not to max it out anymore.

The short answer is no. What you have saved is very likely not enough.

I know what you are thinking. You’re thinking that $250K is a mountain of cash to build on for the next 30 years. And it is, no doubt, an amazing sum to have accumulated by the age of 30.

However, with the numbers presented, and making certain assumptions about your income based on the fact that you were able to save $250K at a young age, it’s fairly safe to say you will not meet your goal.

Why? Three big reasons: Expected Returns, Inflation and Withdrawal Rate.

First: Fees reduce your expected returns.

You’ve assumed that you’ll make 8% per year for the next 30 years. This would be a fair assumption except for two issues. The first is investment fees. Assuming this money is in a typical 401(k), fees from your 401(k) program and from the investment products (funds, bonds and stocks) within it can vary from 0.25% all the way to 2.5%. Those fees are a consistent drag on your returns.

Fees on typical 401(k)s can vary from 0.25% to 2.5%. Those fees are a consistent drag on your returns.

For perspective, a 1% drag on an 8% return means that you’ll have $1.9M in 30 years, not the $2.5M you are expecting.

The second is returns. Eight percent, net of fees, per year is an extremely aggressive return to expect for any reasonable asset allocation given current market fundamentals. It’s not impossible, but it’s not something you’d want to bet your retirement on.

If you assume a return of 6% net of fees instead of 8%, now you are talking only $1.4M in 30 years.

The next kicker:  Inflation really matters.

The problem with your assumptions is that a dollar today is not going to be worth a dollar 30 years in the future. To be specific, what a dollar will buy you in the future will be much less than what it does today.

You know how your parents tell you that back in the day, a candy bar was 25 cents?  It’s basically that issue.

Your $2.5M won’t really feel like $2.5M in 2043. It’ll feel like a little over $1M does today.

Over the past five decades, inflation has roughly accumulated at 4% per year. That means that by the time you are 60, it will take about $3.24 to buy what $1 buys today. Even if you believe that inflation will only be 3% annually over the next 30 years, that still means that the price of items will be about 143% higher than it is today.

So, your $2.5M won’t really feel like $2.5M in 2043. It’ll feel like a little over $1M does today.  What about that $1.4M number, which is the one based on more realistic market returns? That converts to $592K in 2013 purchasing power.

The final blow: You can only withdraw a small percentage every year.

Even if you have $2.5M in 2043, there is a final problem. Exactly how long are you going to live again?

Making money last through retirement is an increasing problem, largely because life spans keep increasing. (We’ll ignore the debate about the Singularity for now).

You might live to 70. You might live to 80. You might live to 100.

How much of your money can you afford to peel off every year? Do you know if you’ll live to 70, 80 or 100?

So how much of your money can you afford to peel off every year? Exactly.

Research has shown that a well-diversified, low-fee, tax-efficient portfolio can afford to throw off about 4% per year, and still preserve its capital long term. This is just a high likelihood – markets are volatile, and there are still scenarios where you run out of money. But let’s assume 4%.

Four percent of $2.5M is $100K. Given the fact that you’ve saved $250K by the age of 30, odds are this is below your current income / lifestyle.

Whoops, forgot about inflation!  That $100K really feels like $41.5K. Definitely less than you are used to. I’m not going to even run the number for what happens if your returns were 6% net of fees instead of 8%. (OK, I did it. $23,662 per year. Blame Excel.)

(There will be those who will tell you that a variety of insurance products can get you higher effective withdrawal rates. They are technically correct, but the insurance products have significant limitations and, usually, high fees.)

Please, tell me there is some good news.

There is. People retire every day.  How do they do it?

  • Social Security.  I know it doesn’t sound like much, but it’s inflation adjusted, and at full contribution, it can be close to $35K per year. Using the 4% rule, you start to realize that it might take you $875,000 to provide that benefit.
  • You live on less.  If you are saving 15% of your salary now, that literally means you are living off 85% of your income. That means you don’t need to match your full income retirement, just the income to match your lifestyle.
  • You make do with what you have. The reality is that many people find ways to live within what they have in retirement. Costs of living vary drastically across the country (and the world), and prudent retirees “right size” their lifestyle to their situation.

You need to save a lot more than you might think.

Saving has an amazing dual benefit: It stores away value for the future, and ensures that you live below your means in the present.

The question reflects an individual who likely has high income and is a prudent saver.  That’s the only
way to amass $250K in a 401(k) in such a short time.

Since you are so disciplined, it’s possible that one day you’ll have enough to stop saving for retirement. The answer to the question of when depends on the lifestyle you want in retirement. Where do you want to live? What you want to do? How long you believe you are going to live? (Let’s be clear about something we all know: “retiring at 60″ when your lifespan might be 95+  might not really make sense in the future).

For now, I’d look at it this way: Markets are volatile. The future value of investment assets is not fully known, and the length of time you’ll live is uncertain, too. Saving has an amazing dual benefit: It both stores away value for the future, and ensures that you live below your means in the present.

Keep saving.

Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Past performance is no guarantee of future results.

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10 Responses to “Does It Ever Make Sense to Stop Saving For Retirement?”

  1. Zach August 11, 2013 at 6:17 am #

    I may have missed something, but won’t the investor have to pay taxes when he withdraws the money from his 401K?

    • Adam Nash August 11, 2013 at 8:22 pm #

      You didn’t miss it – I didn’t cover taxes in this post for several reasons. The main reason, however, is that tax situations are extremely variable and unpredictable, especially decades out. It can vary based on the state you live in now vs. in retirement, alternate sources of income / assets, spousal assets, and of course the impossibility of predicting tax structure 30+ years in advance.

      The truth is, for many young investors, they have a lot of confidence comparing the annual income, pre-tax, they might receive in retirement with their current compensation, which they tend to think about in pre-tax terms.

      You might enjoy the earlier post I wrote on Traditional vs. Roth 401(k)s, if you are interested in how taxes affect 401k decisions.
      https://blog.wealthfront.com/roth-401k-vs-traditional-401k/

  2. Jamie August 23, 2013 at 10:27 am #

    “Eight percent, net of fees, per year is an extremely aggressive return to expect for any reasonable asset allocation given current market fundamentals.” This sounds a lot like market timing to me. If you truly believe that current market fundamentals indicate that certain asset classes will under-perform in the future, isn’t there a way that you can leverage this to increase your returns (e.g. via options)? On the one hand, you are suggesting that we should assume a return to the longer-term historical averages when projecting inflation (higher than it has been for the past 20 years) and on the other hand we should assume lower returns on our assets. The deck is stacked in favor of investing more money.
    I guess if I told Campbell’s that I eat soup every day for lunch, I shouldn’t be surprised if they responded that I should eat it every day for breakfast and dinner too.

    • Adam Nash August 23, 2013 at 5:12 pm #

      I can understand your skepticism, but please don’t confuse a long term estimate (30 year+) for market returns with market timing. There is a wide body of academic research on expected returns for different asset classes over long periods, and you’ll find that a vast majority of it would not support a long term rate of return at that level.

      As with anything at the macro level, you do get into large-scale economic questions of size of the economy in 30 years, percent of the value captured by private businesses, multiples that investors will demand. The purpose of highlighting the assumption as “aggressive” was just to provide context compared the aggregate body of respected projections & bodies of analysis available.

      On the charge that we actively encourage people to save more & invest for the long term, we’re definitely guilty as charged.

      Take care,
      Adam

  3. Colby November 5, 2013 at 7:31 am #

    Hi Adam,

    I have a follow up question. What if the original poster was 55 and had 2.5 million in his 401K, and planned to retire at 60. Let’s also assume his annual income is 75K. Would it make more sense to continue to max out his 401K annually, or instead use that 23K per year to enhance his lifestyle between the ages of 55-60? A 23K contribution to a 2.5 million 401K account represents less than 1% of the account’s value. But a 23K contribution the worker’s lifestyle would represent a 10-20% lifestyle increase, after taxes.

    • Adam Nash November 5, 2013 at 9:23 am #

      Hi Colby,

      This is a very different question, but the frame to solve it doesn’t fundamentally change. You always have the chance, like the grasshopper, to enjoy the summer, or like the ants, save for the winter. The issue really isn’t the amount of the contribution vs. the size of the 401(k). The real issue is what are your lifestyle (and therefore income needs) in retirement.

      One of the great ironies of financial planning is that, if you choose to increase your lifestyle now, you make it doubly hard to retire comfortably. First, by saving less, you’ll have less money to live on in retirement. Second, by improving your lifestyle now, you’ve increased your spending expectations, which means you have to actually provide more in retirement to match that lifestyle.

      The more fundamental questions to ask in the scenario you pose have to do with when that person will choose to retire? What are the risks that they will face early retirement or income disruption? Are there other dependents (parents / children) that might impose unexpected expenses? What lifestyle do they expect in retirement?

      The short answer is that increasing lifestyle is one of the most expensive and risky financial changes you can make.
      Adam

  4. Vince November 25, 2013 at 11:24 am #

    There exists an inherent assumption of inflation in all of these calculations. The USD has lost 93% of its purchasing power since 1920, this reads as if it will lose another 93% of its purchasing power AGAIN.

    This accepted regime of maintaining 3% inflation policy simply results in all of us losing half of our purchasing power every 24 years!

    • Adam Nash November 25, 2013 at 1:23 pm #

      Yes. We assume a moderate level of inflation going forward over the long term.

  5. Chris February 24, 2014 at 8:33 am #

    The math in the article seems incorrect to me. If you are going to assume 6% return, then I have to believe that number is being sourced from a post-inflation return, or a real return. SP500 has a real return of 7%-ish after inflation.

    I think this article is misleading, possibly the has incorrect economic assumptions, and ultimately wrong. At best, it’s sandbagging the stats to be overly pessimistic.

    More likely a 9 to 11 percent stock return should be assumed pre-inflation, depending on allocation. Subtract your fees of .5 or less percent (2.5% fees? really? that’s a whole other article), then adjust for 3-4 percent inflation.

    Or… just stick with the 6% and do the math simply in real dollar terms for the future equivalent value and have a good conservative ballpark.

    • Andy Rachleff February 26, 2014 at 8:15 am #

      The 6% public equity return we assume is based on what the market itself is expecting. It is based on a combination of the capital asset pricing model and the current price of S&P 500 options. We explain this in detail in our investment methodology white paper. We do not think it makes sense to do our calculations on historical results.

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