Millennials’ finances are already stretched by student loan debt and housing costs, but there’s another factor to consider: Compared with their parents, they may need to save much more of their income for retirement, according to a new NerdWallet analysis.
A number of analysts predict that the slower growth of the U.S. economy after the Great Recession could cause stock market returns to fall from 7%, the current annual average, to a possible 5% in the decades to come. And that could hurt investors.
22% could be the new goal for retirement
The difference of two percentage points has big implications for younger adults who are just starting to save for retirement and also for those who’ve been investing for about a decade. NerdWallet’s analysis shows that millennials, who could earn a 5% return over the bulk of their investing lifetimes, may be required to save 22% of their annual income to make up the gap. Most retirement experts currently recommend saving 15% of annual income.
“The era of supernormal returns is over,” says Martin Small, the head of U.S. iShares for BlackRock, the world’s largest asset manager. “Over the longer term, younger investors should expect yields and equity market returns to be low.”
To help a millennial investor prepare for the future, NerdWallet analyzed the saving needs of a 25-year-old earning $40,000, the median salary for ages 25-29, according to the U.S. Census Bureau’s 2015 Current Population Survey.
Based on the 7% average in stock market returns each year since 1950, a 25-year-old earning $40,000 can meet a common retirement goal of replacing 80% of his or her income by age 67 by saving 13% of annual income.
But if average annual stock market returns fall to 5%, NerdWallet’s analysis shows a 25-year-old will have to set aside 22% of annual income to save the same amount. That’s an increase of $3,400 this year — equivalent to over three months of rent, based on the median monthly rent of $937 for 25- to 29-year-old households.
How millennials can start preparing now
While nobody can predict investment returns, here are ways to help prepare for your financial future.
Start saving. Putting off saving for retirement carries a heavy cost. Our analysis found that if a 25-year-old millennial waits until 35 to begin saving for retirement, he or she must save a nearly impossible 34% of income annually, or $16,400, to retire at age 67 with 80% of income, assuming 5% annual returns.
Even if you can’t set aside the income required to reach your future goal, every dollar of retirement savings counts. In addition to saving more income, lower investment returns mean millennials may need to start contributing earlier to a retirement account than their parents did or plan for longer careers. Use a retirement calculator to assess progress toward retirement goals and identify potential gaps.
“The biggest advantage millennials have is time,” says Arielle O’Shea, NerdWallet’s investing and retirement specialist. “If these lower returns become a reality, it will be that much harder for those who put off investing to catch up. The best thing millennials can do is invest as much as they can as soon as they can.”
Take advantage of tax benefits and employer matches. Some 98% of employers who offer a 401(k) plan match at least a portion of employee contributions, but estimates show a quarter of employees aren’t contributing enough to get the full match. That match is free money that gets you closer to your savings goals. A dollar-for-dollar match — the most common arrangement — doubles your savings rate up to the amount of the match.
A 401(k) also helps you save when it comes to taxes today. If a millennial must set aside an additional $3,400 this year and has a 20% effective tax rate, that’s a federal tax savings of $680, and the savings goal met at a net cost of just $2,720.
Those who don’t have a 401(k) can get a tax deduction by making contributions to a traditional IRA. Investment earnings in a traditional IRA grow tax-deferred and, as with 401(k)s, distributions in retirement are taxed as income.
Don’t stash your retirement money in a savings account. According to a 2015 survey by the research group Statista, millennials are almost four times more likely to put extra cash into a savings account (42% of respondents) than to invest it (11%).
“Millennials may be focusing on building an emergency cushion, but they shouldn’t let that goal push saving for retirement down the road,” O’Shea says. “It could take many young workers years to build up the recommended three to six months worth of expenses in an emergency fund.”
If you’re struggling to balance both goals, focus first on earning your employer’s 401(k) match and setting aside at least $500 in case you need quick cash. Then, consider opening a Roth IRA account and start funneling savings into that. While it is still intended for retirement saving, a Roth IRA offers flexibility if you need the money. Because contributions are made with after-tax dollars, they may be pulled out any time after five years without taxes on the gains or a penalty for early withdrawal. And keep in mind that the returns on investments in stocks or bonds can be expected to significantly outpace the small yields of most savings accounts over the years.
Pay attention to investment costs. Whether you are investing in a 401(k) or an IRA, there are ways to keep more of that money. Exchange-traded funds (ETFs), which allow investors to build a low-fee, diversified portfolio, can save millennials hundreds of thousands of dollars over their lifetime, according to a NerdWallet analysis earlier this year.
Robo-advisors also provide low-cost investment management, with features like automatic rebalancing to help you keep taxes to a minimum. They’re a good fit for many millennials who would prefer a hands-off approach to their retirement portfolio, with low minimum investment requirements and easy diversification through ready-made ETF portfolios that are tailored to the investor’s age and risk tolerance.
“Uncertain future returns are the reality of investing,” O’Shea says. “Millennials need to focus on controlling what they can control: Saving as much as they can, taking an appropriate amount of risk for their very long time horizon, keeping their investment expenses low and grabbing all available tax advantages.”
Quick facts on millennials
Millennials are good savers. According to a Transamerica Center for Retirement Studies survey, 72% of millennials are saving for retirement, and 30% are saving over 10% of their income.
Millennials have higher housing costs. A median 25- to 29-year-old spends 27% of income on housing, compared with 21% for Americans ages 45 to 64, according to the U.S. Census Bureau’s 2013 American Housing Survey.
Millennials are burdened by student debt. In 2013, 55% of households headed by Americans in their twenties had student debt. In 1992, that number was 17%, according to a Center for Retirement Research at Boston College analysis of the Federal Reserve's Survey of Consumer Finances.
Retirement savings were calculated for a 25-year-old making $40,000 a year, with 2% annual income increases until retirement at age 67.
Annual investment portfolio returns are calculated as 7% in a normal scenario, and 5% in a slow-growth scenario, based on investing in a broad basket of stocks like an index fund or ETF that tracks Standard & Poor’s 500 Index.
Retirement savings rates are based on replacing 80% of annual income (based on the average of the last 10 years of income) at age 67, with a 4% annual withdrawal rate at retirement. Savers should aim to replace 70-90% of a pre-retirement income, which is the average income for the 10 years leading up to retirement. If you anticipate receiving Social Security benefits, plan to replace 70% of income before retirement. Use this calculator to estimate how much you can expect to receive from Social Security. All numbers are in inflation-adjusted terms.
Retirement savings for the 35-year-old scenario assumes a beginning income of $48,760, the income after 2% increases for 10 years, starting at $40,000 at age 25. This assumes a future annual income growth of 2%, and 5% annual stock market returns through retirement at age 67.