How Much Should I Save for Retirement?

The following is a guest post from Marotta Wealth Management. For related posts on this subject, see The Safest Retirement, How Much Income Do I Need For Retirement?, and Have You Calculated Your Retirement Number?

I'm often asked, "How much should I save for retirement?" My standard answer, based on certain assumptions, is that you should save 15% of your take-home pay for retirement over your working career. As your situation varies, you must adjust your safe savings rate.

A safe savings rate gives you the best chance of having sufficient assets to retire at your target age. Being able to retire does not mean you must retire; it means you have gained financial independence. You no longer have to work for money. Now you can just work for the love of what you do.

I liken retirement projections to the Lewis and Clark expedition heading west to reach the Pacific Ocean. In the beginning, just heading the right direction is enough. But as you encounter challenging terrain, a guide who understands the lay of the land is indispensable. He or she can help you calculate where to cross the Mississippi and which pass is safest to tackle the Rockies. Most importantly, a guide can help you stay on schedule to reach your destination before the winter of retirement sets in and leaves you stranded.

More than half a million pioneers made the trip west in the mid-1800s. They left Independence, Missouri, in early spring traveling about 15 miles a day by covered wagon. It took four to six months to cover the 2,170 miles.

So too have millions of people made the financial trip to reach their goal of financial freedom on 15% of their take-home pay. But if certain assumptions are wrong for your specific situation, you may need to save more or less.

Retirement projections depend on these five factors:

1. Your age and your spouse's age. We generally use the age of the younger spouse, assuming he or she will be the survivor and need longtime assets. This is your start date. If you have already begun saving for retirement, it is the current date.

2. Your target age for retirement. Sometimes the age at which you need to reach financial independence is along a continuum, either because a couple retires at different ages or they phase out their paid employment gradually. At the latest, this is the date when winter will set in and make progress impossible. You need to have made it safely through the Rockies and into the Willamette Valley or risk disaster.

3. Your asset allocation. A narrow asset allocation range provides the best chance of meeting your goals. Too much in bonds dampens your returns. Commission-based investment products laden with high fees/expenses and poor returns make it difficult to get the appreciation you need to grow your retirement assets. This is your method of travel. Covered wagons are the preferred way, but some are better constructed than others. Traveling on foot is equivalent to saving but not investing. Progress will be slow and very painful.

4. How much you have already saved toward retirement. At age 65 you need nearly 23 times your standard of living to survive financially for the next 35 years. At each age you must save a target multiple of your standard of living to be on track for retirement. Falling behind can be corrected but only if caught early enough.

Settlers on the Oregon Trail knew they were making progress as they passed Chimney Rock and Scotts Bluff. Before the final push they had to reach Fort Laramie and Fort Bridger in the Wyoming Territory. With winter storms looming, this was the most critical portion of the journey.

5. How much you are saving each year. If you know the first four variables, you can calculate the fifth one. According to our standard formula, you should save at least 15% of your take-home pay. But this answer is based on assumptions about the other four factors. Typically the goal was at least 15 miles each day. But much depends on how much progress you have already made. Stopping short or failing to make progress risks all your hard work. There is no penalty for arriving early.

Different assumptions for the first four variables require different savings recommendations. Here is the basis for the 15% recommendation.

First, we assume you will begin paid work at age 25 and continue until you are 65, a fairly short working career of just 40 years. If you retire at age 65 and live until 100, you are trying to save 15% of your lifestyle each year for 40 years and then spend 100% for the next 30 years. Believe it or not, this math works.

Starting at age 25, the money you save and invest that year must grow enough to support your entire spending needs at age 65. The money you save at age 26 will grow to support your spending at age 66. Adjusting for inflation, 15 grows to 100 over 40 years by earning 4.86% over inflation. At that rate of return, the value doubles every 15 years. And when you retire, you will have enough for another year.

Appreciating 4.86% over inflation is a decent return. With an average inflation rate of 4.5% it is equivalent to a nominal return of 9.36%. On average, bonds earn 3% over inflation and stocks earn 6.5% over inflation. If inflation averages 4.5%, these are equivalent to nominal returns of 7.5% and 11%, respectively.

People have been wondering recently if these returns are even possible. In contrast, during the last half of the 1990s, people thought these assumptions were pitiful. Regardless of recent history, these assumptions work well over 40-year time horizons. Some of the trip is trudging uphill; other parts are easier going. On average it all evens out.

We also assume you have a well-balanced asset allocation for your age and rebalance regularly. Few people rebalance their portfolios, at least partly because they don't have an asset allocation. There is a rebalancing bonus, but you won't benefit unless you have an appropriate asset allocation. Sometimes the path turns right. Later you need to turn left to balance it out and travel in roughly a straight line. By the end of the journey, all the wheels should have traveled the same distance.

And finally, we assume that if you are older than 25, you have been saving at a rate so you are on track to meet your retirement goals. If a third of your travel time is over but you haven't even started yet, you obviously must save at a much faster pace to catch up.

Comments

[Lance @ Money Life and More]

Very interesting metaphor... I'm glad it appears I am on track as I am in my mid twenties and have been saving at least that much! Nice to know I'm on my way to Oregon.

[Roger @ The Chicago Financial Planner]

Nice post. As a fellow financial planner I appreciate the detailed logic and the entire thought process.

[Old Limey]

The assumption that a 11% average annual return from the stockmarket is likely for the next 40 years assumes that the USA is in normal times.

Unfortunately we are far from that. For the first time in its long history the USA is facing a fiscal cliff at year end when the limit on the national debt must be raised. The Federal Reserve bank has just initiated the QEI program (Quantitative Easing to Infinity), one reason that gas and food prices have been rising. There is also the stubborn jobless rate of 8.2% average across the states. If anyone thinks that these are normal times then they have had their head in the sand for the last five years. Because the Fed is pumping so much money into the investment banks the stockmarket is now disconnected from the economy's dismal statistics and most of the trading is done by the computer trading programs at Wall Street's big banks. The small investor is totally at their mercy.

The bond market is affected far less by this but historically it has made smaller returns than the stockmarket.
Since 9/1/1988 Vanguard's S&P500 fund's ANN=9.67% but with a Max Drawdown of -55.26%.
Since 9/1/1988 Pimco's Total Return Bond fund's ANN=8.84% with a Max drawdown of -6.63%.

One fund I have owned this year is Pimco's Income fund whose ANN=23.35% YTD, Max Drawdown -0.89%.

I know it's almost impossible for busy working people to do, but if you subscribe to a fund database that is updated daily, comes with good software tools, and you have the time, education, and mental ability to learn the skills required to use them you can vastly outperform the average investor by staying in the strongest, low volatility, funds at all times rather than following the crowd with their index ETFs.

In my own case I retired at age 58 in September 1992 as a software engineer with $320K of investments. Our fixed gross income from our pensions and SS now totals $65K/year and our investments have grown to over $7M. The only withdrawals we have made, since 2005, are to pay the taxes on the MRDs due on our IRAs every year.

[Mark]

Old Limey,

Wow...$320K of investments at 58 seems really meager. We're in our early 30's and have managed to accumulate twice that all on our own with fairly modest incomes. However, I know that I'll never be able to reach the $7M threshold no matter how much I invest. Right now everything is about market timing.

With that in mind, what is you prediction for stocks over the next six months? I'm also in Vanguard's Intermediate Municipal Bond Fund and GNMA Admiral, but even so, I worry about municipalities quite a bit these days and sometimes I wonder if the 2% yield on these is really preferable than just putting $ into a 1% CD.

[Cherleen @ My Personal Finance Journey]

My husband and I have been saving for our retirement since we received our first paycheck. Aside from our personal retirement savings account, we are also paying for our retirement contributions. But as I have been saying, I do not have a specific age when to retire. I will keep on working, writing and blogging for as long as I can.

[Tammy]

It is a shame more people don't realize the importance of saving for retirement in their 20's rather than a decade or two later. The pragmatic approach of 15 percent of your salary makes a big difference down the road.

[Old Limey]

@Mark
You forget that salaries were a great deal lower in my days compared with today. In 1960 as a junior engineer at the largest aerospace company in the USA I hired in at $9,000/year. When I retired in 1992 I was a senior staff engineer, with an MS, making $72,500/year. My wife worked part time for about 16 years as a teacher's aide and retired in 1993 making $13,500/year. By comparison my 48 year old son, with only a high school diploma, just got promoted to US Western region sales manager for a large international company at $162,000/year. This may make you think about how high prices will be in another 30 years. The good thing however is that by the time you retire you own most of all the things that you need and don't have to buy much for the home other than maybe a new appliance now and again.

I cannot predict what the stock or the bond market will do over the next 6 months, I don't have a crystal ball.
There are generally 3 classes of municipal bond funds, short term, intermediate term, and long term. The best no-load municipal bond fund this year has been BCHYX. On 12/30/11 it was $9.60, today it is $10.13. For the YTD it currently pays a monthly income of 3.6c per share and has an ANN=12.2% and a Max Drawdown=-0.91%.

The short term muni bond funds vary little in price and pay a much smaller monthly amount. My wife recently received a low 6 figure inheritance that she wants to be kept separate from our investment portfolio so it's in a short term muni bond fund called STSMX that has a YTD ANN=2.61% and a Max Drawdown of -0.10%. I don't worry about the stability of municipal bonds, most of them also carry insurance. I own 110 different groups of municipal bonds with maturities ranging from 11/15/2012 to 10/1/2040 and an average yield of 4.98%.

[Robert]

To add to the above, set something aside for the possibilities of Health Issues that are not covered by Medicare/Medicare Advantage plans or other Insurance.

If one is assuming to live to 100, the prospect of developing some type of condition requiring Assisted Living/Memory Care/Alzheimer's increases dramatically after 80. Causes are many for this condition.

A combination of Long Term Care Insurance, Social Selectivity Income, Investment Income and other Income can make the "Cash" payments for that care. But what if only one of the couple is beset by these conditions?

I see this first hand in my Parent's. Mom has severe to profound Alzheimer's and probably should be in some type of facility. In the last 6 months has been in the Hospital and then Skilled Nursing/Rehab twice, for a total of 2 months. Of course Medicare pays for that. We are trying to help both parents age in place in their Condo. This requires the need for Caregivers to be hired and paid from cash reserves.

Their LTR and VA benefits covers only a portion of Facility care and would require the paydown of many assets to cover the additional costs. Current costs in our area are in the $9,000 to $11,500 per month range in an appropriate facility. And who knows the life span of Mom? From my calculations they have enough in Investments, SSA, Retirement Income, VA Benefits, and other sources to cover them until death. But, and I say but, there is a small probability that they could exhaust their monies and then have to go on Medicaid.

Since I have become directly involved in their care, I have come across a large segment of the population, doing the same thing as I. Many are friends from High School, after I moved back home.

Oh BTW, Mom only started showing signs of Dementia in the summer of 2009, just 3 years ago. She is now 89. Prior to that, they traveled extensively and enjoyed their Retirement.

Conclusion: Set aside some money for unexpected Major Medical Expenses. I have been going to special training sessions, conferences and so on regarding the subject. I have come across a lot of walking wounded: Spouses, Children and Family trying to take the best care of their Elders and wading though the maze.

One last thing: make sure all of your Legal Documents are in order if such befalls you or someone else in your family. Thankfully, my parent's did that.