How Much Should You Save? | Jonathan Berk & Jules van Binsbergen

In this insightful discussion, finance professors Jonathan Berk and Jules van Binsbergen delve into the complexities of retirement planning, including how much one should save, the variables affecting these decisions, and the pitfalls of a one-size-fits-all approach.

They propose a basic economic model for retirement savings and challenge some conventional financial advice, offering alternative perspectives and strategies.

A Basic Economic Model for Retirement

The hosts present a retirement savings model assuming an individual starts working at 25, works for 40 years, and retires at 65.

During the working years, a fraction of income is put into a retirement savings account, which is then invested to yield a certain percentage of real return per year.

The goal is to determine what fraction of one’s income should be saved for retirement.

Issues with Employer Matching Contributions

Matching contributions made by employers to their employees’ retirement funds can actually result in those on low incomes who cannot afford to contribute, missing out on a larger portion of their potential retirement savings.

Retirement Planning and Lifestyle Considerations

If individuals want to maintain their current lifestyle after retirement, they will need to save more.

With current low rates of return, rates closer to 20 or 30% may be more appropriate.

Irreversible Nature of Retirement Decisions

Part-time retirement may be a better strategy, as it allows individuals the flexibility to return to work if needed.

Working Longer Than Planned

If individuals cannot afford to save the recommended 20% of their income for retirement, they may need to accept the possibility of working longer than they initially planned.

Critique of Common Financial Advice

The common advice to save 10% of one’s income is critically examined.

To maintain 70% of post-contribution income in retirement, one would need to achieve a 5% real return per year, which is deemed as exceptionally optimistic.

Achieving a comfortable retirement at 70% of one’s post-contribution income will require significant annual savings.

Influence of Income Growth on Retirement Savings

Higher income growth rates can increase the amount one needs to save, as the retirement goal is based on the final income.

For instance, if the income growth rate increases from 1.5% to 5%, the savings rate needs to increase from 10% to 20%.

Flexibility in Retirement Age

The idea of a fixed retirement age is critiqued.

Retirement age should be flexible, depending on one’s wealth situation and personal circumstances.

This flexibility can add a lot of value to people’s lives and can help manage uncertainty regarding income growth rate.

If you want to put it in the stock market, then you have to entertain the possibility of losses and therefore you won’t have enough money to retire on. Return doesn’t come for free. – Jonathan Berk

Critique of the Pension Sector’s Uniformity

The pension sector’s focus on uniformity, such as having the same target date fund, pension plan, investment strategy, contribution rate, or retirement age for everyone, is criticized.

There is a huge heterogeneity in people’s professions, lifetime success, preferences, and social contexts that is being ignored.

Habit Formation Model for Savings

The habit formation model implies that people who are used to a certain lifestyle or level of wealth will want to maintain it in retirement.

Therefore, they need to save more, not less.

If the return on savings drops to a 2% real return, then almost a third of the income would need to be saved.

Critique of Target Date Funds

Target date funds, which start with a lot of investments in equity and few investments in bonds, and then over time, move from equity to bonds, are critiqued.

People have very different risk preferences and retirement preferences, making this approach a mistake.