Saving for retirement since your 20s? That could be a mistake

There is much more to life than saving.

Raise your hand if you think that young people who are not saving for retirement are making a terrible mistake.

Most people will probably raise their hands, and that's understandable. There is a broad consensus that American society is facing a retirement crisis because people are not saving enough, and that young people are doing especially badly. The U.S. workforce in their 20s is the least likely to participate in employee retirement savings plans, according to a report by investment giant Vanguard. In the past five years, their likelihood of participating in retirement savings plans has declined even more significantly. They are squandering a great opportunity to have their savings compounded over as long a period as possible. Therefore, automatic enrollment in an employer-sponsored 401(k) retirement savings plan account is a great option.

But what if this thinking is wrong and young people are behaving exactly as the hyper-rational economic model says they should? New research by leading experts finds that many young workers do exactly that. In a just-released working paper, the authors conclude that "optimal retirement savings are zero for mobility-constrained young people who expect substantial income growth."

This fact is extremely shocking and blasphemous in a financial advisory industry that has long advised people to save for retirement to the maximum extent feasible. But the authors of a new paper base their counterintuitive argument on an indisputable reality - that there is far more to life than saving.

This economics literature designates happiness (not savings) as the metric that needs to be maximized. The new paper focuses on "overall life satisfaction from material consumption," according to Stanford University professor John Schowen, one of the authors of the article, in an interview with Fortune magazine. Schowen is a leading expert on retirement economics, Social Security, Medicare and pensions.

Life satisfaction is basically not a new concept in economics. It is in fact what economists call utility. The economic model created by Shawn and his colleagues assumes that income can be used for consumption or for saving; if it is used for saving, it can be deposited into retirement plan accounts like 401(k)s with varying percentages of employer matching contributions or into taxable investment accounts. The future utility of spending today's savings is discounted for three reasons, according to Schowen: "People act impatient; in the distant and unknowable future, they may no longer be alive; and in the future they may also suffer health problems, such as suffering from dementia."

The model assumes that a worker born in 1995 starts working at age 25 and retires at age 67, with Social Security replacing 34 percent of his or her after-tax income; the model also includes minimum distribution requirements for retirement accounts.

In the past, interest rates were higher and most of the workforce was made up of high school graduates whose inflation-adjusted income would have increased only slightly over their careers. According to Schowen's model, the traditional advice that people should start saving for retirement at the beginning of their employment makes sense.

However, after adding a few reasonable assumptions based on today's environment, the conclusions begin to change. College graduates at age 25 earn only 42% of their peak income at age 45 or 50, and the inflation-adjusted interest rate (a measure of safe investment returns) is extremely low, at about 0%. In this scenario, a rational person who wants to maximize overall life satisfaction would not start saving for retirement until age 41, and only if their employer matched 50% of their 401(k) plan contributions; without an employer match, they would not start saving until age 44.

And if the inflation-adjusted safe rate of return is higher (up to 3%), they will rationally start saving earlier. But even then, they won't start saving until age 37 (when their employer will match contributions to a 401K plan) or before age 40 (when their employer will not match contributions to a 401K plan).

These findings will come as a shock to many because the approach is completely irrational. Shouldn't the workforce start saving earlier - not later - when returns are lower? Similarly, if employers don't make matching contributions to their 401(k) plans, shouldn't they start saving sooner? Note, however, that the goal is not to maximize savings, but to achieve the highest overall life satisfaction. When returns on investment are low, workers have little incentive to sacrifice today's consumption for consumption that will barely increase in a few years. Employer matching contributions enable workers to achieve a certain level of savings with less sacrifice of current consumption, which is why they are willing to start saving earlier.

The authors of the literature also acknowledge that the reality is more complex. People save for reasons other than retirement, to buy a house or to prepare for unexpected events; it may be wise to start saving before having children, because saving becomes more difficult after having children. Nonetheless, they say, "Our overall argument still applies to retirement savings that occur in illiquid employer-sponsored pension accounts."

This brings us back to automatic enrollment in 401(k) plans, the most notable trend regarding retirement savings over the past decade, and Vanguard says that half of its plans of record now require participants to opt out of retirement plans rather than opt in. This structure has been applauded by many. But this new study raises an important caveat. The authors conclude that "automatic enrollment, which applies to workers of all ages, may be driving young people to make mistakes rather than preventing them from doing so."