The Goal of Retirement

This post might seem a little wonky, and may also seem irrelevant to the average 55-65 year old, since we are going to turn back the clock to the good old days when you had the whole world ahead of you. However, I believe that it's important to frame retirement in terms of a retiree's entire working (and post-working) life, as it puts all of your hard work into financial perspective.

Human Capital - your personal "market value"

Picture yourself as a fresh college or trade school graduate. The possibilities seem endless, and every entry-level job description has references to candidates with "high potential." Your 21 year old self has very high "human capital," even if your "investment portfolio" consists of the $17.00 in your wallet and $0.37 in your couch cushions.

How do you quantify this nebulous term "human capital?" In this case, it represents how much an investor would pay to acquire a share of your salary for the remainder of your career. We will make some basic assumptions to get the ball rolling:

1. Your investor expects your salary to be locked in at the current rate, but includes yearly raises to account for inflation; 
2. This salary continues until retirement age (which we assume to be 67); 
3. The price that you demand for a share of your income is equal to a lump sum of money that would be invested in a conservative portfolio that would be able to fund payments equal to your salary until age 67; and
4. Everything is on an after-tax basis.

For this example, we start our industrious young 21 year old professional - we'll call him "Joe" - with a $40,000/year salary (again, after taxes), which increases every year with inflation. The return Joe can expect from investing his "buyout" from the investor is 2.0% per year after taxes and inflation (or 4%-5% including inflation). Why I believe 2.0% per year is the "right" number is outside the scope of this discussion, but will most likely spawn multiple future posts.

At age 21, the "fair price" for Joe's future salary is $1,195,693. Not bad for a guy who, just last year could barely make it to his 8:00am accounting class. Joe is a millionaire!

But wait, there's more!

Let's assume that Joe is smart and hardworking, and is lucky to have landed at a growing company. As a result, his salary grows faster than inflation. We will assume 2.5% faster for the purposes of this discussion. So, on an inflation-adjusted basis, his salary as a 22 year old is now $41,000 ($41,820 including 2% inflation). So, despite having one less year left in his career to pay his hypothetical investor, his market value - er, human capital - climbs to $1,209,097. In fact, it continues to climb throughout the early part of his career, as his raises and promotions pile up.

Human Capital has its Limits - Financial Capital to the Rescue!

Of course, there's a catch. Joe's human capital is increasing at a decreasing rate, as his hypothetical investor is looking at a shorter and shorter time to harvest the fruits of Joe's labor. In fact, Joe's market value peaks right about age 37, at $1,329,907, and starts to decline over the next 20 years or so - first at a very gradual pace, then much more quickly in his 50s and 60s.

This peak and subsequent decline in human capital is the fundamental reason why you need to build a growing pile of financial capital, by tapping the world economy. Now, you get to be the investor, sizing up companies and harvesting their earnings, just like Mr. Investor sized you up. Financial capital has it's benefits - no need to commute or deal with a nagging boss, and no need to put on a suit - the dividend and interest checks that drop into your bank account don't care about any of that!

The trick to making this transition work smoothly is to regularly carve off a pieces of your human capital to invest in other places, effectively balancing spending with savings during your working years.

Let's say Joe wants to earn $60,000/year (in current dollars) when he retires at 67, because he estimates that he can supplement it with at least $20,000/year of social security benefits (which will be the subject of several future posts) and $80,000/year should fund a comfortable lifestyle, with a little extra for golf and trips to visit the grandkids. How much does he need to save, based on all of the previous assumptions? Assuming he can earn 2.0% after inflation on his investment portfolio, he would need to save a little more than 25% of his pay every year from 21 to 66 to hit this goal, which would be to accumulate $1,279,569 by the end of age 66. If that sounds like a big number, it is! Most people don't even save 10% of their pay every year (which is the subject of more future posts!)

Plotting out the progression of Joe's career in the chart below, you can see how his human capital starts out very high, then tops out in his late 30s. However, his saving habits and prudent investing quickly build his financial capital, which crosses over his human capital in his late 50s. Interestingly, Joe's total (i.e., human + financial) capital peaks at age 52, at $1,756,241. It's no coincidence that the early to mid-50s are termed "peak earning years."

Once Joe gets the proverbial gold watch at age 67, he shuts off his salary and taps his portfolio and social security benefits to fund his lifestyle, in this case until his passing at the ripe old age of 95).

This is just a starting point. You can imagine how it can get more complicated. There are changing tax rates (and ways to optimize them), different ways to save (and get your employer to help you out), and a million different ways to invest your financial capital to get the best possible return for your risk appetite. There are also contingencies to plan for, such as long-term care, college costs, housing, "unbudgeted expenses," charitable giving and bequests to your heirs. Sometimes insurance can help, sometimes you just need some "wiggle room" in your plan.

Just to reiterate, this is a very rough example. Please do not interpret any of these assumptions as guarantees or hard forecasts. Everybody's situation is different, and life has a way of veering off of carefully planned paths - for better or worse!