I recently received this question via email and since it is probably the most asked question I receive at work as well I figured it would be a good idea to tackle it here. Everybody wants to know how much they should be saving and how large their account should be once they reach retirement. There are two methods to help guide you.
Rules of Thumb
The most common method is simply by using one of the general rules of thumb about retirement income. For years people have been told that you need to earn 75-80% of your pre-retirement income during retirement to maintain your lifestyle. This is a fine place to start but there are simply too many problems with this method.
First, we can’t predict the future. We can make some assumptions as to why we will need less income during retirement such as not having a mortgage payment or no longer commute to work but nothing is certain, especially if you have quite a while yet before retirement. Another huge factor is health. While you may not have a mortgage payment during retirement you could find that you replace that with high insurance premiums or medical care that wasn’t expected.
Creating a Detailed Estimate
A better way to determine how much you should save up for retirement would be to create a detailed estimate based on your specific situation. This means sitting down and taking a look at exactly what expenses you will or won’t have in retirement, what sources of income you will gain or lose, and any lifestyle changes you may have.
Some people will still carry a mortgage while others won’t. Some people may choose to buy a second home or move to a new location in retirement. And depending on what you do during retirement will have a huge impact on your income needs. Maybe you want to travel overseas frequently or maybe you want to join that private golf club you’ve always dreamed of, or maybe you plan on starting a business. You may find you can live comfortably on 25% of your pre-retirement income or you may find you need 150% of that income to reach your goals.
The problem with this method is that this really works best for those who are approaching retirement within maybe the next 5 to 10 years at the most. Beyond that it is difficult to get a real grasp on your financial needs because your situation may still change. For those of us in our late 20′s and 30′s we have to rely on assumptions for the most part. We really don’t know where our careers might take us, how our income grows and what our plans are 30 years down the road.
What The Experts Say
A relatively new study done by a few experts was published in the April Journal of Financial Planning to tackle this exact topic. The study aims to address the following:
- The annual cash flow needed in retirement
- The capital needed to generate this lifetime retirement cash flow
- The annual savings needed to build the capital that will provide the retirement cash flow
An interesting note as to why this study is a bit different can be summed up with this:
We used a more sophisticated approach by using the retirement ratio of 80 percent based on pre-retirement net income as defined as gross income less retirement savings. We used net income because someone who saves for retirement has reduced their pre-retirement living expenses and, for most, it typically follows that they also reduce their post-retirement expenses. For individuals who are saving a lot, this can be significant. Lower retirement expenses means less needed capital. You could say the more one saves, the less one needs to save.
In the past the assumption was simply based on gross income. If you earned $50,000 just before retirement then you need to have $40,000 coming in during retirement. This study factors in savings because if you are saving money each year for retirement, once in retirement you won’t be saving and instead withdrawing so that shouldn’t count towards your required income. For example, let’s say you make $50,000 a year and you are putting $6,000 into your 401(k) each year. Instead of just taking 80% of $50,000 you would take 80% of $44,000, or a retirement income of $35,200.
Capital Required to Generate Income
While it is fine to make estimates about how much money you need in retirement, whether it is based off 75%, 80%, 120% of your income the other big question people have is how much money does it take to generate that stream of income? When I meet with clients they are often quite distressed. They hear things in the media about how they should have over a million dollars saved up and with $150,000 in their account and 5 years until retirement they think it is the end of the world.
The same study talks about how to estimate how much capital will be required to generate this stream of income. It goes into detail using mortality rates, social security, the Monte Carlo simulation and so on. Since it is complex I won’t go into detail here but I encourage you to check out the study and take a look at some of the tables they have provided that give some sample income levels you can use to compare with your own situation.
What This Means For You
After all of this discussion you are probably just as confused as before. Making general assumptions only goes so far, yet if you’re getting close to retirement and put together a detailed estimate you’ve already missed out on a lot of time needed to save, so what should you do? Ultimately you shouldn’t get hung up on some of the numbers out there. Just because some talking head says you should have a million dollar portfolio by age 65 doesn’t mean that is what you should strive for, just as the rule of thumb saying you need to save 10% of your income or have 80% of your income during retirement. People are unique and everyone’s situation is different.
Use these guidelines as a starting point. Read the study and go over some of the examples they provide. While in the end they are still general assumptions they are a great place to start. It is then up to you to monitor your progress and make changes as things in your life change. It is hard to say where life will take you so your actual savings goals may change significantly. If you start saving early and find out you’re saving more than you need to that is a good problem to have. It doesn’t hurt to overestimate because you can do even more in retirement or leave more to your heirs or charity, but if you realize at age 50 that you haven’t saved nearly enough you can’t go back in time and fix it.