Public Ponderings

Young Adults Have It Harder Today, And That's Canada!

daniellin:

A blogger compares earnings and cost of living in 1984 vs 2012. And that’s just Canada, where higher education is heavily subsidized by the government.

From Redditor BenE:

Household income doesn’t tell the whole story. We also need to take into account the proportion of that income that needs to be saved for retirement.

Here is an interesting fact: My house whenever I can afford it, will not be the most expensive thing I will have to buy in my life. My retirement savings are.

With lower expected long term investment returns and interest rates, the expected cost of securing retirement annuity goes up steeply and there is much less money left for everything else.

All the the news article I read on the subject of house prices assume that low interest rates prop up prices since they allow for cheaper financing and lower mortgage payments. However, as a 30yo who would like to one day be a homeowner, this is not the effect low interest rates have on my budget.

The low interest rates are currently more than offset by low expected returns on investments which make it much more difficult to save for retirement.

I decided to try to quantify the effects of low returns on my budget:

I calculated that if we managed to get 4% real returns on our savings, which is what most online savings calculators assume by default and about what the previous generation got, we would need to save 23% of our income to maintain standards of living after retirement (This includes home equity and what the government saves on our behalf those “entitlements”).

If real returns were 3%, we would need to save 27% of our income, if they were 2%, we would need to save 35% and 1% would require saving 42%. This assumes a saving period from the age of 30 to 60 and retirement from 60 to 90. This is somewhat optimistic but with two equal periods of 30 years, it makes one data-point easy to calculate: With 0% real returns, to maintain standards of living. we would spend half the money before retirement and half after so we’d have to save 50% of our income.

Long term real returns going down from 4% to 2%, increases the amount we need to save by 12% of our income. This means we have this much less money to put on housing and other things. For example, if our after tax household income was $50 000. We would need to save an additional $500 a month ($6000 a year) for retirement.

Is it even possible nowadays to get a safe 2% real (~4% nominal) return? The investment opportunities I see are closer to 0.5% or 1%.

Meanwhile the cost of financing a $200 000 mortgage go down by $4000 a year or $333 per month when mortgage rates go down by 2%.

If I bought the same house when returns and mortgage rates both went lower by 2%, I would need to find an additional $166 per month ($2000/year) to keep my retirement savings on schedule. If I decided to recoup this $166 per month by buying a less expensive house, at 4% interest, it would have to be $50 000 cheaper.

I realize that expected returns and mortgage rates don’t necessarily move in sync and it may be that mortgage rates have bigger downward moves than expected returns but this still all makes me uncertain about my ability to spend on houses while saving for retirement. I guess that worst case scenario, my generation will have to work till 75.

Here is the math I did for reference:

I : Annual Income S: savings ratio

The amount saved each year of my working life is I x S The amount spent each year of my working life is I x (1-S)

For example, if our household after tax income I=50k and we save 10k for retirement, S=0.20, we get to spend 40k that year.

We would like to maintain our standards of living after retirement which means we would like the amount we spend I x (1-S) to be equal the amount of our retirement pension payments. That is, if we save 20%, (spend 40k, save 10k) we would like to get a 40k pension at retirement.

The value of our savings at retirement should be enough to give us this annuity. To calculate S, the proportion of our income we should save to achieve this goal, I take:

Future Value of my savings FV(I x S) = Present Value (at retirement) of the pension annuity PV(I x (1-S))

Taking the formulas from here: http://en.wikipedia.org/wiki/Time_value_of_money

I arrive at

S = 1/( x + 1 ) where x=1/((1-1/(1+i)^m)/((1+i)n - 1))

(See https://picasaweb.google.com/lh/photo/rdEbvkw5wx78_dnqZuL4QtMTjNZETYmyPJy0liipFm0?feat=directlink )

i is the real (above inflation) returns on my investments which, assuming I don’t take too much risk, should follow the trend of long term real interest rates. n is number of years we are savings m is number of years we plan to be retired.

Lets say, that I start saving for retirement at 30, retire at 60 and live to 80. That’s 30 years of savings and 30 years of being retired, a somewhat optimistic scenario (n = m = 30).

Here is the graph showing how much we should save relative to long term real returns on investments (https://picasaweb.google.com/lh/photo/d4vj9i43MIPd8H7MqUq_BtMTjNZETYmyPJy0liipFm0?feat=directlink ).

TL;DR - You better start saving for retirement right out of school, and not at 30 something.

I know that something that strikes you quickly and immediately after graduating is paying off student loans and home-ownership. With no outside assistance, this is an increasingly daunting task in today’s world. With the staggering debt left to us by the baby boomer generation, I see no way out in the near future.