The pandemic and the subsequent recession have exacerbated the challenge of saving for retirement. Real interest rates, as measured by the difference between nominal 10-year Treasury yields and the Cleveland Federal Reserve’s inflation expectations, fell half a percentage point in early 2020 (see Figure 1 below). . Although rates appear to have increased slightly since then, they remain well below zero. This persistently low rate environment means that workers will have to contribute significantly more to their 401 (k), or invest in riskier assets, than they did at the turn of the century.
To give an idea of how much more, we (actually my colleague Anqi Chen) estimate the required contributions for middle earners, who are supposed to have a target replacement of 75% of pre-retirement income and will receive 40% of pre-retirement income from Social Security if they retire at 67. If they retire before full retirement age (FRA), they will see a lower replacement rate from Social Security and therefore need a rate of highest replacement of your 401 (k) plan. On the accumulation side, we repeated the calculation for a series of real interest rates, and on the decumulation side we assumed that they bought a single annuity consistent with the current real rates. The results for a median wage earner who begins saving at age 35 are shown in Table 1 below. With a 3% real interest rate, a 401 (k) contribution of 9.6% of earnings, when combined with Social Security, will produce the target replacement rate of 75%. This contribution rate is in line with the combined average contribution rates (employee plus employer) that we see among Vanguard participants. If the actual return falls to 2%, 1%, or 0%, the required contribution rate increases to 12.2%, 16.8%, and 24.2%, respectively. And if the worker retires before age 67, the required contribution rates become astronomical.
While I am sure we did the arithmetic correctly, I have a couple concerns with the trade-off implications. For one thing, no one buys an annuity, and any reduction plan, such as the 4% rule, will produce less income during retirement and therefore require even higher contribution rates. On the other hand, we have not taken into account the higher returns derived from equities. In theory, the return on stocks should be the real interest rate plus an equity premium. Therefore, the risk-adjusted return on equities is simply the real interest rate. But it doesn’t seem so simple in real life, and we may be exaggerating how much people need to save by not considering stocks.