In the previous article, we looked at the growing interest in financial independence. We considered how that affects retirement. In this article, we will seek to answer one of the pertinent questions when it comes to retirement – how much should I save for retirement.
It is important to state at the onset that retirement is a very personal affair. This is one area where you have to recognize the ‘personal’ in personal finance. Many of the decisions will depend on your situation and preferences.
How much will You Need in Retirement?
The first step when it comes to discussing how much you should save for retirement is to determine how much you will need at retirement. It is only logical that the money you will need to save will depend on how much you will need.
According to Fidelity, you will need between 55%-80% of your pre-tax annual income at retirement. What this means is that when you retire, you will not need to replace 100% of your current pre-retirement income. If Dave earns $50,000 annual pre-tax income prior to retirement, he will only need between $27,500 (55%) and $40,000 (80%) in retirement.
You will only need a percentage of your income and not the full amount because of some expenses that go away or decrease at retirement. At retirement, you will no longer contribute to retirement. You will pay lesser taxes, lesser insurance, and incur lower daily expenses (transport and clothing, for example).
There is an inverse relationship between current income and retirement ‘income’ (By retirement income, I mean the amount you need during retirement). The higher your current income, the less the replacement rate ceteris paribus), vice versa.
You can do the calculation on your current income or what you expect your income to be in the year preceding retirement. To be conservative, you should do the calculation on your current income (if you expect a significant increase in your income over time).
Also, if you earn less than $100,000 annually, it is better to choose 80% of annual pre-tax income as the amount you will need at retirement. This table from Fidelity gives you the percentage you should select for every income bracket. However, to be conservative, you can stick to the 80% rule.
What Percentage of ‘Retirement Income’ Should Come From Savings?
Now that you know how much you will need at retirement, the next thing is to discuss what percentage of that amount will come from your nest egg (savings). To know this, we have to consider two critical factors.
Retirement savings is not your only source of income at retirement. There is Social Security. Depending on your job, there is also pension payment. Some people may also decide to earn some part-time income.
These three income sources will cover a certain percentage of what you need at retirement. Let’s continue with the example above. Let us say Dave needs $40,000 (we choose the 80% rule) annually during retirement.
Dave can expect $17,500 (35% of $50,000, the pre-retirement, pre-tax annual income we used in the calculation) from Social Security based on his income levels. Social Security payment varies inversely with income levels. The higher your income levels, the less you get, vice versa. Another factor that determines what you expect from Social Security is the age you retire. The earlier you retire, the lesser the amount you can expect from Social Security during retirement. The above calculation assumes Dave retires at 67. If he retires before 67, Social Security will fall. If he waits until 70, it will increase. If you retire before 67, attributing 55% of retirement income to retirement savings will be a conservative estimate.
If we assume that Dave will not work part-time and his work does not pay pensions, this means he will need $22,500 ($40,000-$17,500) at retirement, which is 45% of the total amount he needs at retirement.
It is a common rule that you will need your savings to cover 45% (if you do not retire before 67) the annual ‘income’ you need during retirement. However, this rule works only if you do not expect money from pension and part-time work. Even if you do, it is still a good practice (to be conservative) to use 45%.
Another factor to consider is the expenses you incur during retirement. As a rule of thumb, your expenses will decrease during retirement. However, this will depend on your lifestyle. Some people may pursue a more expensive lifestyle, like traveling around the world or large donations to charitable causes.
If you expect to be in this situation, you can increase the percentage you need from retirement savings or change retirement income to 100% of annual pre-tax income.
How much Should You Save?
Now that you know your retirement ‘income’ and the amount you need from savings, you can now determine how much you will need to accumulate in savings by retirement and how much you will need to be saving right away.
The 4% Rule
The first and simplest approach is the 4% rule. All you need to do is divide the retirement income by 4%. The resultant figure is how much you need to have in savings at retirement. (The 4% rule assumes a return on investment of 5% after taxes and inflation)
Dave will need $1,000,000 at retirement ($40,000/4%). The 4% approach does not consider Social Security. It assumes that there will not be Social Security Payment. In that sense, it tries to be even more conservative.
We can tweak the formula to account for Social Security Payment. In that case, Dave will need only $562,500 ($22500/4%). If you want to be more conservative, you can choose the former figure.
Annual Income Multiples
This approach calculates the money you need to save to meet a particular annual income multiples target at different periods.
One of these approaches requires you to save an amount that will be 1X your annual income by age 30. You accomplish this by saving 15% of your yearly income beginning at 25 and investing 50% of that amount in stocks.
In Dave’s case, he will need to have $50,000 in savings at age 30 by saving $7500 (15% of $50,000) every year from age 25.
At 40, you will need to have 2X your annual income. It will be 4X at 50, 6X at 60, and 8X at 67.
In another approach, you will accomplish 2X by 35, 3X by 40, 4X by 45, 5X at 50, 6X at 55, 7X at 60, and 8X at 65. However, in this approach, you will save 25% of your annual income during your 20s.
An alternative is to use retirement calculators. These calculators will give you more personalized calculations. They will put many essential factors to play to determine how much you need in retirement savings at retirement and how much you need to be saving. Below are some of those calculators:
- Nerd Wallet: They factor in your current total savings, age, pre-tax income, and monthly savings. The calculator will return how much you will need to save and how much you will save based on the data inputs. It will also return a percentage value to see how close you will be to what you need at retirement (what you will save/what you need).
- Millennial Money: It requires data inputs like current retirement savings balance, date of birth, target retirement age, safe withdrawal rate, monthly contribution, investment growth rate, inflation rate, the expected tax rate on retirement account withdrawal, and expected annual retirement expenses.
- Vanguard Capital: Inputs include how many years you want your savings last, current savings balance, and monthly expenses. The calculator assumes a 50% investment in stock, 30% investment in bonds, and 20% investment in cash. The result will show you a probability that your savings will last.
- Bank Rate: Inputs include current age, age of retirement, annual income, annual retirement savings, current retirement savings account balance, expected income increase, retirement income, and the expected years of retirement. The output will be when your retirement savings run out. You can also tweak the return on investment estimates (before and after retirement), the inflation rate, and the percentage of current income (remember the 55%-80%) that you will need in retirement. There is also an option to include marriage and Social Security Payment as a factor.
Pulling It Together
So which of these approaches is best? I believe you should use a blend of the annual income multiple approaches and the retirement calculators. The retirement income we calculated will be a prominent figure in many of these calculators. Use the 4% rule, the annual income multiple, and some blend of the retirement calculators.
With the 4% rule, you will get a figure for how much you need to have in savings at retirement. The annual income multiples approach already have a set saving rate (15%, for example). If you are comfortable with that rate, you can use this approach. The advantage of the calculators is that you can easily simulate. What if you are saving 10% instead of 15%? What if you now want to retire earlier? You can easily factor in these questions with the calculators.
My personal opinion? The Bank Rate calculator is the best approach. Input all the figures (including the ones we have shown you how to calculate above) then start tweaking the annual retirement savings % until you come up with a percentage where your retirement savings will last you for the years of retirement income (how long you want to keep taking from the retirement savings). If you’re going to retire at 67 and expect to live to 90, the years of retirement income will be 23. Keep tweaking the retirement savings percentage until the calculator tells you your savings (based on the data inputs) can last until 90.
The resultant percentage figure that gives you that green light is how much you need to be saving every year.
If the % that gives you that green light is too high, you can tweak other factors (inflation rate, return on investment, and increase in your income, for example). However, try to be as conservative in your estimates as possible. Also, do not be surprised that you can save more than you think.
Concluding Dave’s Example
Let us make the following assumptions for Dave.
- Age: 40
- Years of retirement income is 18 (live until 85 years).
- The balance on his retirement is only $100,000.
- Annual retirement savings: 10%
- Retirement age: 67
- Increase in Income is 0% (conservative)
- Rate of return before retirement is 5% and after retirement is 4%
- An inflation rate of 2%
- Married: Yes
Without Social Security Payment, all of these inputs give us $611,135 retirement savings, which will last for 18 years.
If we include Social Security Payment, the money will last Dave even beyond 85. At 85, he will have more than $900,000 extra.
If we add five more years to the years of retirement income, Dave will not have more than $1,000,000 at 90.
If he does not want all these extra money, he can tweak the annual retirement savings down a bit. If we set it at 5%, Dave will now have only $755,431 at age 90. If his retirement is 100% of current annual income, he will still have more than $200,000.
Therefore, this means that Dave only needs to save 5% of his annual income (towards retirement).
However, I will still advise you to talk to a professional to get some expert advice before making your conclusions.
One of the fundamental things when it comes to retirement is deciding how much you need to be saving every year (as a percentage of your total income). When you know this figure, it will make your retirement planning easier and smoother.