Arguably the most important financial planning decision you’ll ever make is deciding if you have enough savings to provide adequate income to sustain your standard of living throughout retirement.
A close second will be to determine how much you need to save today to be comfortable tomorrow. Yet too many of us are projected to fall short. The so-called portfolio sustainability crisis (the inability of assets saved for retirement to provide sustainable income throughout the retirement period) is well documented and generally universally acknowledged in the financial planning field. Popular press headlines decry that “Americans fall short on retirement income.” And according to the Employee Benefit Research Institute’s Retirement Readiness Ratings, over 40% of people are not expected to have adequate retirement income to fund 100% of simulated basic retirement expenses.
Finally, the Boston College Center for Retirement Research’s National Retirement Risk Index indicates that more than half of today’s households will not have enough retirement income to maintain their pre-retirement standard of living, even if they work to age 65—which is above the average age at which people are currently retiring.
So how big should your nest egg be? The answer depends on who you ask. Let’s review some rules of thumb, and then I’ll ask you to do some homework.
First, remember that numbers never (always?) lie. You will need to stretch your savings over an indeterminate amount of time under uncertain personal and economic circumstances. So the short answer is that there is no definitive “retirement number.” No rule of thumb or retirement calculator can account for the myriad variables that will mark your future.
Will you use an extraordinary amount of costly and uninsured health services? Will inflation wreak havoc with your purchasing power? Will your portfolio thrive or dive? Will you need to make your savings last for 10 or 40 years? No simple number or financial rule of thumb can accurately predict the future financial path that awaits you in retirement. In other words, it would be a happy accident if the assumptions that the most skilled financial planner uses to calculate your retirement need actually matched your retirement reality. Yet a target number is the best we can do. The fear of outliving savings commands that we make a plan and set a goal; no matter how flawed. But be careful, as the saying goes, “If you want to make God laugh, tell Him your plans.”
Rules of thumb
Essentially what you are trying to do is evaluate the net present value of projected assets against projected liabilities. Seems simple, right? Wrong! There are many precepts scholars and financial service firms have suggested. All of these represent good intentions of intelligent and well meaning people to provide guidance and to discourage you from taking a wild guess regarding how much you will need to save each year and how much you need to accumulate when you’re done. However, these guidelines will vary from your actual need, and from each other, based in part on the underlying assumptions used.
Here are five rules of thumb to assist you:
- Make it your goal to have 15.7 times your annual pay. This comes to us courtesy of Hewitt Associates. Since Social Security will provide 4.7 times your pay, you need to save 11 times your annual pay in an IRA, 401(k), or other retirement vehicles. (See also 5 checkpoints on your race to retirement.)
- Calculate whether you’re on track for your current age. This comes to us courtesy of Fidelity. They suggest that you have 8 times your ending salary by age 67 to meet your basic income needs in retirement. To accomplish this goal you should have one times your salary at 35, two times your salary at 40, three times your salary at 45, four times your salary at 50, five times your salary at 55, six times your salary at 60, and 7 times your salary at 65. (See: Retirement savings: How much is enough?)
- Use a safe savings rate to ensure income adequacy. This comes to us courtesy of fellow RetireMentor Wade Pfau, who suggests a safe level of savings of a little over 16% of salary a year might be a reasonable target. The good news is employer matching and nonelective contributions count toward the 16% rule of thumb. The bad news is people need to start early in their careers; otherwise the amount they need to save increases.
- Make it your goal to save 11%-15% of pay- According to the Principal Financial Group, maintaining a similar standard of living during retirement requires an estimated annual savings rate of 11% to 15% of income over the course of your working career. Once again, it is fair to count the employer match or other employer contributions. Principal cautions, however, that merely maxing out the company match will typically leave you short of this goal. One other caveat: High-income earners may need to save at higher rates, since a lower percentage of their income will be replaced by Social Security.
- Catch up after a late start. The Boston College Center for Retirement Research found that if an individual begins saving for retirement at age 35 and does so for 30 years until retirement, the average household needs to have an annual savings rate of 14% of pretax income to maintain the standard of living they had before retirement. For low-income households it is 11%, for middle-income households ($41, 501 to $76,500) it is 15%, and for high-income households it is 16%.
And now for the homework. My first preference would be for you to have a financial professional use sophisticated proprietary software to complete both an accumulation and decumulation retirement analysis for you. Their “total savings needed at retirement,” “target annual savings needed,” and “annual withdrawal strategy” numbers are going to be better than anything you can do for yourself on the web.
However, if a professional analysis is not in your future, then I suggest you go to the web and try several of the bazillion calculators that come up when you search for the term “retirement calculator.” I just tried the AARP calculator, the MarketWatch calculator, and the “Ballpark Estimate” calculator from the educational outreach program Choose to Save, and each took less than five minutes (not very much homework!).
In the Ballpark Estimate and some other calculators they will ask you to enter the desired percentage of your current income you would like to receive during retirement (the replacement rate). Typically planners are comfortable with a replacement rate of between 60% and 80%of final salary. This rule of thumb comes to us courtesy of Bruce Palmer, formerly of Georgia State University, and Aon Consulting. It accounts for changes in taxes and spending that are likely to occur in retirement.
I prefer to use an alternative to the replacement rate, using something called the expense method. The expense method asks you to estimate the budget you will have in the first year of retirement (ignoring onetime expenses, like that trip around the world). More often than not the expense method budget calculation comes out to be 60% to 80% of final salary anyway…on the other, hand the exercise of calculating your budget for the first year of retirement is an eye-opening experience.
Common Sense Observations
So now you understand the rules of thumb, and perhaps you have even calculated how much you need to save each year to reach your retirement target number. What’s more important is that it is time to do something. All the following ideas may fall into the “no kidding” category, and we may be stating the obvious, but prudence dictates we must mention them:
- One wild card that can blow up even the most well laid plans is health care expenses. Retiree medical costs make up on average 20% of retirement needs. You should strongly consider Medigap and long-term care insurance.
- If you work past 65, you can more easily reach your number. If you find your financial preparedness is lacking, you should strongly consider continuing to earn a salary.
- If you start saving early, it’s easier to meet your number. I tell my students at Widener University to start saving right from their first paycheck.
- How much you accumulate is a function of savings and investment performance. Save more and earn more!
- Adverse investment returns are especially damaging during the period right before retirement or at the beginning of retirement. One way to mitigate this is to withdraw less in the early years of retirement.
- Maximizing Social Security benefits by delaying claiming will help the situation in most cases (even if you have to draw down 401(k) assets to do it).
- Increase your savings rate by 1 percentage point each year until you reach the desired annual savings rate. You probably won’t miss the money, but it will add up quickly.
Retirement preparedness is elusive for many. But you need a plan for providing a paycheck in retirement. Calculating the amount you need, heeding the rules of thumb, and taking the required actions to accomplish your goal will provide a good start. In the end, maybe the answer to the question “Can you afford to retire?” will be, “YES!”