Q&A with Charley Ellis: What millennials need to know about retirement

Known as the dean of American investment advisors and one of the founders of the index investment revolution, Charley Ellis served on the board of the Vanguard Group and the Yale Endowment, and founded Greenwich Associates, one of the world’s leading investment research firms. He wrote the classic bestseller Winning the Loser’s Game and, more recently, co-authored Falling Short: The Coming Retirement Crisis.

In your book, you wrote of your fear that millions of Americans would end up poor, old and alone if we don’t act soon. What’s the state of retirement security in America?

Charley Ellis: Close to half the people working in America do not have any coverage other than Social Security. Social Security was defined originally as poverty insurance, and it is insurance against extreme poverty. It’s not livable for most people in retirement. So the first question is, can we find a way to provide coverage? The answer is sure. Are we going to? That's a very different question.

The average Social Security payout is $1,342 a month. Not many people could live on that. But what makes you think there’s an easy fix?

Charley Ellis: Well, Australia has a retirement system based on mandatory savings. Singapore has it. And in Singapore, most children send their parents a check every month to help them live in retirement. Chile has a retirement system, too. It's not a question of whether we can do it. It’s a matter of deciding we're going to have retirement security.

If you were going to build a system to make sure Americans have a secure retirement, what would it look like?

Charley Ellis: You could mandate retirement savings one of two ways. Either you say an employer must provide a vehicle for retirement security, or you say every person must have a vehicle. Singapore’s strategy is that every person has to have one. In some ways, an individual mandate makes it easier to get to 100% coverage for Americans. If you put the mandate on employers, you can move to 80%, 85% or 90%.

The idea that we don't want to have more regulation is, in my view, gobbledygook. We allow a tax deduction on contributions that you make as an employer. We as a society ought to be looking at this, because we have a fairly large number of people who are not covered. This is going to be terrible.

The idea of a “mandate” is anathema to a big segment of the American population, especially those in the conservative and libertarian wings of the Republican party.

Charley Ellis: How much does Congress spend encouraging people to participate in tax-free returns? How much does that cost the Treasury? The number I've heard is $160 billion a year.

If employers and employees want those deductions, do something that's good for the nation and society and for your workers. Agree to a nationwide requirement that employees or workers all provide or have retirement plans. In exchange, we get this wonderful tax incentive. It's not God's given right. It was a Congressional decision.

What about people who aren’t saving enough?

Charley Ellis: It's certainly more than half of those who do have coverage. That really represents, what I think of, as a dangerous reality because people think: “I'm participating, I'm covered.” But most people do not know how to convert assets to flows or flows to stocks. And, it's very hard for people to understand how low the returns are.

Consider the numbers: Bonds return 2-3%, but you have to subtract inflation. That means, bonds net only about 1%. Stocks return 6-7%. After inflation, that’s only 4-5% a year. (Those numbers are average over the life of a portfolio). It takes a lot more money than people are putting aside to be anywhere near ready for how long they’re going to live.

What if you’re a young person, and facing the question of whether to pay off student debt or save for retirement?

Charley Ellis: The first thing is simply to have awareness about saving and retirement planning. For young professionals, the key financial priorities should generally be to:

What makes this challenging is that you may also be paying down student loans, saving up to get married, start a family, or buy a house, all while getting your career established. In other words, you will make a lot of important financial decisions in your 20s and 30s!

However, for retirement, remember that your 401(k) is the best tax-sheltered investment opportunity available, especially if your employer matches your contribution. You should invest as much as you possibly can after you’ve established your emergency living funds, and if you don’t have high-interest debt. The annual limit is $19,500 for people under age 50.

How much income do people need annually in retirement, excluding the massive health care costs at the end of life? One estimate is 60% of your pre-retirement income. Seventy percent seems to be a little on the high side.

What is most important for young people to know about the retirement landscape now?

Charley Ellis: First of all, plan to work longer. If you claim Social Security benefits at 70 1/2, you get 76% more every year than if you claim at 62 AND, if you have a 401(k), you also get 8 years of not taking money out, plus 8 years of putting money in ( and our sixties are the easiest years in which to save), and 8 more years of returns on all your investments. Combine the two and millions, I repeat millions, get lifted from too little to enough. What a difference that change would make for all those individuals and their families and to our society and our politics!

Second, think about a typical couple coming into retirement. They are your parents, perhaps.

The typical guy looks around and says "So how much do I have? I've got more money than I dreamed I'd ever have, and it's all in my own name. In my 401k plan, I've got $120,000 smackers. My wife and I are gonna go down to Florida and play tennis and golf with all those nice young people. We're gonna have some fun for the first time in our lives. We're gonna travel, we're gonna do the things we really want to do!”

To sustain their lifestyle, after Social Security (the average couple collects $2,340 a month), they have enough to live for two or three years. The actuarial tables say they’ll live to be 86 or 87. They’re going to live off their children, if they’re lucky, for a full 15 years.

What do you suggest we do to encourage people who have plans to save more early, and what do you do to help the people who didn't save enough?

Charley Ellis: Well a couple of things that are pretty straightforward. Let’s take it step-by-step. First, all retirement plans in the country should be opt-out instead of opt-in, so that people are automatically enrolled but can make an affirmative decision to opt out. Most of corporate plans have switched, and are switching their 401k plans too. Public and union plans are just getting started in the same migration.

What savings rate should be the default?

Charley Ellis: Depends on what your age is. It would be 4% or 5% as a fine starting point in your 20s. And then set up plans so a third of every raise you ever get, gets added to your retirement savings. Pretty soon you'll get up to greater than 10%, which is what we all ought to be saving.

Also, make it harder for people to borrow money and make it harder for people to cash out. Make it possible for them to cash out, but slow down the speed with which they can say "We're going to take a year and just have some fun, and then we'll come back and work again.” It's a choice, but it's not a very good choice.

What’s next?

Charley Ellis: I would also call for an immediate, nationwide public education program on better investing. It would emphasize a handful of things.

First — your earnings is the single biggest economic value you've got. You are worth more by a long shot than your portfolio. Inflation protected, as long as you live, if you put off retiring from 62 to 70 and a half, your Social Security payment will be 76% higher.

If you do the calculations and include the fact that at the same time you’re still earning, you won’t be taking money out of your 401(k), you come out at over 200% more per month

Second — don't overdo the bonds. Ignore that old saw: 30% in bonds at 30, 50% at 50, 70% at 70. On a strictly objective basis, a person of 45 and in good health, will work to 70 and live to 90. With that much time, zero bonds is the rational way to invest. And when you get to 65 or 70, whatever your retirement age is, part of your portfolio should still be invested in equities.

Ah, you say, but we are not 100% rational. We are human. We will misbehave if we see the stock market going way down, so to protect ourselves from ourselves, we need to hold bonds so our average experience is less “interesting,” less volatile.

Maybe so, but why not learn enough so we don’t get the jitters when markets rise and fall? The opportunity cost of not learning is huge. For a lot less, you can pay yourself to learn enough to behave better or less badly. We do not have to be ignorant.

It’s not only individual investors who need to be educated. The big problem with balanced funds and the automatic investment plans is that they tend to be more conservative than they really ought to be. They have too much in bonds.

There’s a penalty cost for being careful. The reason for being careful is people just don't know how to think about market fluctuations.

Last — market fluctuations are a reality. It's not how the stock market did today, it's not how the market did this year. The question is how will the market do on average per year over the next 30 or 40 years, because that's the relevant time period. So 7 or 8, maybe 9% annual returns on average?

That much?

Charley Ellis: I hope in the longer term, maybe. Even if you said 6% annual returns for stocks, that's a lot better than putting money into bonds that start at 3%. My biggest pitch is that we should start a massive educational program to teach people the basic realities of what's available to them. Save more, invest realistically, and work longer.

When people understand better what it takes to retire, it may help us develop the national will we need to ensure everyone has access to a secure retirement.