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Sunday, May 10, 2015

Average Joe on the Path to Retirement

According to Census Bureau data, the real median income of a household 10 years ago was $65,000.  This is where we 'll start our average Joe. Today, Joe's household income, adjusted for inflation, again from median Census Bureau data, is approximately $67,141.

The following simple exercise shows how Joe has done on the path to retirement if he followed some basic guidelines.

Tables from the book Your Money Ratios by Charles Farrell show that a 40-year-old on track to achieve an 80% income replacement at age 65 should have a nest egg of 2.4 times his income.  In average Joe's case, this amounted to 2.4 * $65,000 = $156,000.  This is what his nest egg should have been 10 years ago.

Farrell's tables also show that Joe should have been saving roughly 12% of income or $7,800/year (.12 * $65,000).  In case you're interested, Farrell also says that Joe's mortgage should have been 1.8 * $65,000  = $117,000 and his household education debt should have been zero.  Given these stipulations, at 40 years old, Joe would have been on a path for a successful retirement.

But how is Joe doing today at 50 years old given market performance over the past 10 years?  Most studies show that the average investor underperforms the market by a significant amount.  This is because the average investor jumps in aggressively when prices are high and panics when prices are low.  For our purpose, we'll assume that average Joe isn't like the average investor.  Instead we'll assume Joe invests in low-cost, well-diversified index funds.

For our performance data, we will use the chart produced by BlackRock.  The chart shows annual performance for a diversified portfolio comprised basically of 65% stocks and 35% bonds.  This is the portfolio whose performance we update each quarter.

For the purpose of the analysis, I used $7,800 as the amount Joe saved each year.  This amount would ratchet up according to plan because Joe's salary increased but also because Farrell suggests the saving rate be ramped up to 15% at age 45. I  kept it simplistic at $7,800/year.

Joe's goal, as given by Farrell's tables, is to have 5.2 * $67,141 = $349,133 to be on plan at age 50.  The following table shows the year-by-year results:

Start of Year
Amount  in Nest  Egg
Diversified Portfolio Performance
Annual Saving
-23.0% *
+20% *

The results in the table were obtained using a bankrate calculator.  I used the calculator to calculate year-by-year returns assuming Joe contributed $300/week to a qualified, 401(k) type plan.  The calculator doesn't handle negative investment performance or returns exceeding 20%.  For those years, I used rough estimates to calculate by hand.  The performance numbers came from the aforementioned BlackRock chart obtainable from the link above.

The diversified portfolio is weighted as follows:  35% Barclay's Aggregate bond index, 10% MSCI EAFE index, 10% Russell 2000 index, 22.5% Russell 1000 growth index, 22.5% Russell 1000 value index.

The bottom line is that Joe is not doing badly, with a portfolio above target by approximately $73,000. In fact, Joe would have probably done better because most 40-year-olds would be more aggressively invested than with a 65% stocks/35% bonds portfolio.

Disclaimer:  info here is for educational purposes only.  Individuals should consult a professional and do their own research before making financial decisions.

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