It is a big problem that Americans are not saving enough, and it ought to be important when people gauge the logic of making unsecured credit available at any price.
There is an argument out there that has been propogated by advocates of payday lending, buy-here pay-here car lenders, and other high cost credit products. Here is one example, from an interent payday loan broker:
Some of us live from paycheck to paycheck, and when an emergency happens in between, we’re really messed up because we’re broke. It is at these times that a quick payday loan is like a miracle. What if you chip a tooth or suddenly need two new tires? If with insurance, you still need to pay the dentist something, and there’s no tire company that is just going to give you free tires.
You need money, and you need it quick. Payday advance lenders can have money in your bank account in a few hours at the most. It is so easy to qualify. All you need is a computer with Internet access. There is no faxing here. You sign everything electronically, and the money is yours. There is no need to cash a check because the money is directly deposited into your account. It’s practically like a Christmas present....Take it all in stride even if your money is short. Don’t get all crazy; just relax. A quick payday loan can fix everything.
Except that a payday loan doesn't fix anything.
Our economy isn't what it used to be. Even when there are plenty of jobs, many people are just barely getting by. There are too many jobs that only pay $9 per hour. On the cost of living side, the news is even worse. Health care costs continue to go up for everyone. Many families are burdened by the high cost of college tuition. Even though incomes have stagnated, prices for big purchases have not. It costs $25,000 to buy a no-frills midsize American sedan.
The other day, a financial planner laid it out for me. He put it this way: a successful retirement is one where you don't have to put yourself at the mercy of the generosity of the government. I couldn't disagree with his logic, even if his judgment of "success" was a bit dour. I often think of a successful retirement in terms of a long period of of
healthy and active living. Yes, he said, that is good. But successful in terms of retirement is merely about not being vulnerable. That is why he could assert that dying at 58 would constitute a successful outcome. There's also the question of how much you are willing to test success. I don't think I would be happy with a plan that is successful sixty-five percent of the time. The idea that there is a 7 in 20 chance that I'll be penniless is not really thrilling.
His numbers were challenging. Imagine that you will live for twenty years after you retire. It isn't unreasonable, even if it might be a bit conservative to assume that you will live well into your 80s. With that time horizon, you need your assets to last.
Here's the basic formula:
(1 /number of years of retirement)*(how much money you want to live on)
By that formula, you need to retire with $1 million in order to live on a budget of $50,000 for the next twenty years. That isn't easy street, of course. People imagine a lifestyle that includes travel and chances to be generous with their grandchildren. Fifty thousand dollars a year isn't that kind of life.
Sure, this is very simple and it ignores the opportunity to grow your asset base. If you want to make a formula that accounts for portfolio appreciation, it becomes a bit more complicated. I constructed a theoretical portfolio of $1 million at retirement. Here are my assumptions:
- A random rate of return on equities that had a mean of 7 percent and a standard deviation of 15 percent.
- Bond income of 3 percent
- 50/50 equity to bond allocation
- Social security income of $1,000 per month.
- Taxes of 15 percent on any income earned above $60,000 per year.
- no change in spending, which ignores the possibilty that a person gets sick and encounters enormous health care costs.
I ran twenty iterations of a Monte Carlo simulation. My million dollar retiree had a "successful retirement" in every instance when he or she spend just $50,000 per year. There was one outcome when there was only $4,461 in the bank after 20 years. But then it was more complicated. When the retiree spent $60,000, there were three failures and another expiration with only $8,810. At $70,000, there were eight failures and about half of the remainder ended with less than $100,000 in savings. There were twelve failures when spending reached $80,000 per year.
Those are optimistic projections, because they don't include health care. The cost of getting sick probably wipes out most of the remaining $1 million nest eggs. Moreover, a twenty-year retirement might also be too narrow. The Office of Personnel Management says that the mean age of retirement is 59 years.
Retirement Prospects for Americans
All of this retirement prognostication means that very few Americans are going to have the luxury of having a successful retirement.
You may be aware of the savings problem in America. It isn't just that most households aren't saving from month-to-month. The better explanation is that many households are not saving at all and very few are saving enough. The 2007 Survey of Consumer Finances estimated that the mean asset base for an American household was $120,000. But that was the good times, when stock portfolios were gaining 20 percent per year and home prices were going up and up.
Jump to 2010, and things have changed. While some of the news is good, most of the story is bad. Household savings did reach six percent of income earlier this year. However, the Federal Reserve estimates that net worth has dropped. It is easy to guess the root cause of that fall. Home values have sunk dramatically. One estimate suggests that median net worth is now much closer to $90,000. Some of that is locked up in home equity, too. In instances when individuals own their own homes, the ability to tap equity is a pyrhic victory. Sell the home and then you have to pay rent.
The best way to run the retirement model is to not rely on an estimate of spending. We have a reliable estimate of mean wealth - about $100,000. This is the "rely on social security plan." When I put in numbers for a retiree with savings of $100,000 and expenditures of $50,000, there were not any "successful" retirements.
Realistically, a retiree with $100,000 in savings is going to have to live on very little. When I run the numbers with a budget of $22,000 (which consists of $12,000 in social security and $10,000 in income from investment savings), then there were successful retirements in four out of 20 simulations. I ran it another twenty times, and then there were successful outcomes in five instances.
It is amazing how important it will be for seniors to live frugally. Even a slight dip in spending can make the difference between security and vulnerability. Spending didn't have to go down much further before the retire was able to make ends meet. When he or she curbed their spending by just 10 percent, things were much better. Of course, this is taking 10 percent from a budget that is already cut to the bone. When spending $20,000 per year (including social security), a plan succeeded more than 50 percent of the time over 20 years. A few seniors had more than $150,000 after twenty years.
Maybe the fact that $2,000 in spending is so important should instruct how people view paying high cost interest on a payday loan. While it would be hard to spend $2,000 in payday interest, that isn't the right frame for the question. A lot of payday users are going to spend that money during their "accumulation" years. Fifty dollars at age 30 is a lot of foregone opportunity.
Things probably aren't going to get much better. The younger generations have come of age at a time when the costs of education have gone up. It isn't uncommon to graduate from college with a lot of student loan debt. That only prolongs the period when people begin to save, and it probably assigns them to a lower-risk, lower-return investment allocation.
Going back to the Unbanked
Plenty of people want credit to cover times when things are tough, but many cannot afford it. These numbers show the problem. The "mean" household isn't going to make it. The lower-income, lower-savings households have it that much worse. The cost of servicing the debt for a payday loan is just one more budget problem. It might be a short-term fix, but it is a thumb in a leaky dam. I often hear a justification for payday lending that goes like this: person has a crisis (flat tire, broken dishwasher, sick child) and they need a payday loan to get them through to the next weekend. A CEO at a debit card company told me that his customers can't afford debt. They don't have a one-time cash shortfall, he said. Instead, they live in a constant emergency. They don't experience a cash-flow shortage once every few months. They experience a cash flow crisis three times a week.
In the title of this post, I made the blanket statement that "you can't afford a payday loan." Maybe that was too much of a sweeping generalization. I've had some time to think about it. Here is what I want to say, instead.
If you are a millionaire, and you plan to live frugally when you retire, then you can afford a payday loan.