Let's say you're an average person. OK, actually, we'll say you're a median person. You live in the middle of the country, and you drive only on the median strip.
More importantl, half the people in the nation earn more than you do; half earn less. That's just how it's been all your life. Last year, you earned $51,071 before taxes. You're 60 now, and you've earned the median income since you started working in 1975 - which, conveniently, is when the Census Bureau's data series begins. How much do you need to retire, and what percentage of your income do you need to have saved to get there?
As you can imagine, it's not an easy question, and any hypothetical example will be holier than a Swiss cheese sandwich at a sandwich shop in Lourdes. But the example - and the problems with it - show how difficult it can be to save for retirement, and what some of those difficulties are.
Let's construct a scenario for our median earner. He started work at age 22 after college, and pulled down the median wage in 1975, which was $11,800. Adjusted for inflation, that's the equivalent of $45,788 in 2012 dollars. But we don't care about no stinkin' inflation-adjusted dollars. He earned $11,800, and being a prudent young person, decided that he would save 5% of his salary every year for retirement. In his first year, he saved $590.
Each year, in a happy coincidence that could only happen in the land of hypothesis, he earned the median income in the nation. In 1990, the median was $29,943, so he put aside $1,497. In 2012, he socked away $2,551.
How is our median person doing? Assuming he invested in a blend of large-company stocks (60%) and government bonds (40%), a middle-of-the-road asset allocation, he would have earned an average 11.3% annually, according to Ibbotson Associates. At that rate, he would have had $600,488 in his retirement savings at age 60. Not bad.
Our median man (or woman, we're flexible) still has five more years left until retirement age. Assuming his income rises at the same rate as the past 10 years (1.75%), he saves the same amount (5%) and earns the same amount (11.3%), he'd have $1,044,279.
If he were to invest that in an immediate annuity now, the company would guarantee him and his spouse an income of $4,778 a month. That's $57,336 a year. But annuities have two drawbacks. If they both get eaten by hippos in a freak zoo accident at age 66, the insurance company keeps all their money; and their payment remains the same over time, meaning that inflation will erode the value of their income.
For that reason, most financial planners recommend you start with a 5% withdrawal from your retirement account, and adjust that annually for inflation. Using the 5% rule, our median man would still be able to duplicate his final income, and give himself an inflation bump each year.
By saving 5% a year all his working life, a person earning the median wage could retire with an income close to his final salary. What could go wrong?
Plenty. Let's start with a few of the obvious things.
• Young poverty. Most people don't earn the median wage just out of college. They earn some pathetic wage, hoping to earn more later. In all likelihood, our median man would have earned much less than the median wage in the first five years of his working life, and saved much less. That would have been extremely unfortunate. If he didn't start saving until 1980, his retirement kitty would be $765,699, instead of more than $1 million. Thanks to compounding, those small amounts stashed away early became a significant part of our median man's savings.
• Big bull markets. You probably did a double-take at the 11.3% average annual return since 1975. But both stocks and bonds have earned exceptional returns in the past three decades, despite at least three soul-shattering bear markets in 1980, 2000 and 2007. Whether a mix of stocks and bonds will return the same going forward is debatable, at best.
• Experience. A young person investing in stocks and bonds in 1975 would have been unusual, to say the least. The stock market fell 45% from 1927 to 1973, and bonds had lost money for three decades, thanks to rising interest rates. "My first year in the financial business was in 1973," says Mark Bass, a financial planner in Lubbock, Texas. "At the end of 1974, I was thinking, 'What have I done with my life?' "
Other problems: Retirement accounts we take for granted, such as IRAs and 401(k)s, weren't widely available in 1975. (The average worker still doesn't have a 401(k) available). Our median man didn't experience any extended periods of unemployment or sickness that would have kept him from saving. He invested regularly in the same mix of stocks and bonds, without chasing bubbles in housing, technology or baseball cards. That's a lot harder than it seems.
For people just starting out now, our median man does provide some good lessons.
• Save more and assume you'll earn less. If our median man had earned an average 5%, he'd be staring at a $208,000 retirement balance at age 65. It's better to assume you'll earn less - say, 7% in a mix of stocks and bonds over the long term - and save more. You can control how much you save. You can't control what the stock and bond markets will give you.
• Make use of your 401(k) plan, particularly if it has a company match, and especially if you're young.
• Don't dismiss Social Security. The average payout is $1,269 a month, and it's adjusted for inflation each year. It's brutal trying to live on Social Security alone. But it's a lifesaver if you've ever had a hiccup in your retirement savings.
One final note: Probably the kindest thing a parent can do for a child is to make a Roth IRA contribution for a child in the earliest days of her working years, says Bass. By the time our median man was retirement age, his first five years' worth of savings had grown to 25% of his retirement savings.