What Percentage of My Income Should I Save For Retirement?
We all know that we should be saving and investing for the future, but it’s such a challenge to know how much.
Wouldn’t it be easy if someone would just tell you what percentage of your income you should set aside each month to have enough to retire?
That would be nice, wouldn’t it?
The problem is everyone’s needs are different.
We have different incomes, different spending goals, different standards of living, different lengths in our working careers, different health considerations and life expectancies, and that list doesn’t even touch an infinite number of other factors that will influence just how much we should be saving for the future.
But I’m going to give you a number anyway, or a range of numbers that you can then use to figure out just how much of your income you should be saving.
It will be simple, I promise, but before we get to that I feel compelled to go over some of the factors we’ve considered and how you might need to adjust your own savings rate to account for them.
1) Creating Cash Flow
The first thing I want to point out is we’re saving to build a pool of assets that will produce a sufficient level of income during retirement, whenever that may be.
In other words, how much money would it take, sitting in strategically invested and diversified accounts, to provide enough income for a comfortable retirement?
Another way to think of retirement savings is as stored labor. You’re putting away money from your work now, to provide for yourself when you’re not working later.
You can imagine if you want to be retired for very long or plan to spend a significant amount of money, you’ll need a relatively large pile of money.
Practically, the way this typically looks is you’ll have a certain percentage of your assets invested for the long term (that’s 5+ years) in stocks or stock mutual funds and ETFs, and another portion of your account will be in fixed-income instruments and cash equivalents like bonds, CDs, money markets, or treasuries.
The fixed income and cash equivalents will produce lower returns typically than stock-based investments, but they are much less volatile meaning they won’t plummet in value when you need to liquidate them and spend the money.
Any cash flow you receive in retirement from social security, a defined-benefit pension, an annuity or some other source will actually serve to reduce the amount you’ll need each month.
Since I don’t think Social Security will continue to operate the way it has and these other income sources are somewhat uncommon, I’m not factoring them into the final numbers I’ve provided below.
2) 80% of income
Second, I assumed that we’re trying to replace 80% of your current income.
Why 80% you ask?
The truth is this is a long-held industry standard and it makes some sense if you think about it.
You won’t need the portion of your income that was formerly directed into saving for retirement because you’ll be drawing out of those accounts now instead of filling them up.
You also won’t have earned income for Uncle Sam to snatch 7.65% for Social Security and Medicare.
Finally, most retirees are completely debt-free or have just a little bit to go on their mortgage. (Which is a good idea, btw, because it’s not very tax-efficient to have to realize income in retirement for the sake of paying debt to your mortgage company.)
With that said, more recent studies show that retirees are spending closer to 70% of their pre-retirement income, so you may not need quite this much.
The great news is you should have a high degree of control over how much you’re spending, so there’s a lot of flexibility to adjust this as you see fit.
On the other hand, it is much easier to stomach having too much in retirement than too little. There are loans for lots of things, but I’m not aware of any for retirement.
When in doubt, leave yourself some margin when estimating your spending needs in retirement.
Also, if there’s any one place you should focus most on developing an accurate estimate, it’s your spending. This number, more than any other factor, drives your savings rate.
3) 25x
Since we’ve evaluated spending on an annual basis, we need a conversion to calculate a lump sum that will provide for a lengthy retirement without running out of money.
To do this, we simply multiply the annual spending estimate of 80% of income by 25.
We multiplied by 25 because it is the reciprocal of 4% and 4% is a widely regarded safe withdrawal rate by financial planners all over.
Also known as the 4% rule, this suggested withdrawal rate is the product of a study conducted by a group of professors from Trinity University in the late 90s. It has become the rule of thumb in retirement planning though some argue it is too conservative.
I tend to agree, but again, I think it pays to be conservative when making retirement plans.
There is one major consideration to bear in mind regarding the 4% rule.
The authors of the famous Trinity Study assumed an average retirement term of 30 years.
Since the late 90s, two important things have happened: 1) people are retiring earlier, and 2) people are living longer.
Neither of these is bad, but it does mean your retirement may be longer than 30 years.
As a result, you may want to adjust the 4% withdrawal rate down to 3.5% or even 3% depending on how early you want to retire.
4) Rate of Return and number of Years You’ll Be Saving/Investing
The final factors to account for are how much time you’ll have to save for retirement and what your expected rate of return is over that period.
For investment returns, the numbers in our table reflect an annual rate of 8%. The average annual return of the S&P 500 is around 10.6%. We’re assuming the portion of your portfolio that’s invested in fixed-income instruments will pull your average return down to 8%.
Regarding your investment timeline, due to the wonders of compounding interest, the earlier you begin saving and investing for retirement the less you’ll have to save and invest.
That’s because the interest earned on previous savings begins to earn interest of its own. That is, it begins to compound over time.
Unless you receive a financial windfall, you will probably need the help of compounding interest to reach your retirement goal.
Think of it this way, if a sum of money doubles every five years, at the end of 10 years it would have doubled twice meaning it’s now worth 4 times what it was initially instead of 3.
After fifteen years, it would be 8 times as much, and after twenty years, 16 times.
So, the second ten-year period returns 12 times the original investment while the first ten years only yield 4 times the original amount.
Thus, the longer you allow your investment to compound, the more valuable it becomes. In this way, your time can be more valuable than your money.
The Numbers
The table below lists the savings rate required in order to replace 80% of your annual income for 30 years based on a given number of years preceding your retirement.
So, if you’re starting just 5 years before your target retirement date and expect an 8% rate of return on your investments, you’ll need to save 327% of your income in order to build a big enough nest egg to support your retirement.
If you start 20 years ahead, you’ll need to save 41% of your income. For a 30-year horizon, you’ll need to save 16% of your income and if you have 40 years you can save just 7%.
Clearly, it pays to start early.
Let’s walk through an example to see how this would hypothetically play out over the course of someone’s life.
An Example – Freddie Fire
Let’s assume Freddie Fire is 30 years old and wants to retire when he turns 60.
Freddie’s income is $100,000 and he wants to be able to replace $80,000 of this each year in retirement.
Using the 4% rule, this means Freddie needs a total nest egg of $2 million.
So, beginning at age 30, Freddie begins saving just over $16,000 of his annual salary and does this until he reaches age 60.
Here’s a table illustrating Freddie’s path to his retirement goal with an 8% rate of return:
Notice that after 20 years, Freddie isn’t even halfway to his goal. But after the last 10 years, he has closed the gap.
We cleared $2 million in this example because of a rounding error that was easier to just leave in the calculation than to explain it or revise the savings rate using a number that would be difficult to follow in an example.
Why Close Enough is Close Enough
As I’ve indicated from the outset, there are many ways to adjust one’s trajectory for retirement savings.
Your savings rate, interest rates, number of years to retirement, forecasted expenses in retirement, and your current income are all factors that can change and would impact the final result.
Not to mention that we did not factor inflation into our examples.
I cannot emphasize enough that this is a rule of thumb and that’s okay. You don’t have to follow a strictly linear path to your goal. You can make changes along the way.
Pretend for a minute that you get in your car for a long road trip. You’re going to be in the car all day and don’t know exactly where you’re going, so you pull out the GPS on your phone and plug in the address for your final destination.
What if the GPS gave you a navigational heading instead of turn-by-turn directions or road names and numbers to follow?
It would be useless because unlike navigating in the sky or on the ocean, you can’t travel over land in a straight line.
Well, no one travels to their retirement in a straight line either. Life happens along the way, calling for us to regain our bearings and adjust our course accordingly.
As a result, you should check your progress every once in a while, and tweak your plans.
For example, the years from 2009-2020 represented the longest bull market in history. If you were saving and investing then, it probably put you ahead of schedule for retirement but it’s not likely to repeat itself.
Plotting An Accurate Course
If you really want to develop an accurate forecast for your retirement needs, you need to begin by developing a hyper-accurate picture of how much you plan to spend in retirement.
Spending, not income, defines your total retirement need.
After you have an annual spending total, subtract any income you’ll have from social security, pensions, annuities, and the like.
Next, determine a safe withdrawal rate that you’re comfortable with.
If you’re forecasting a 30-year retirement, you can use the 4% rule of thumb we talked about in this video. If you think you’ll need 40 years of income, consider adjusting your safe withdrawal rate down to 3.5% or even 3% if you think you’ll have an even longer retirement.
Third, forecast an expected rate of return.
I mentioned earlier that the S&P500 has returned a little over 10.6% since its inception, but that would mean you’re in a 100% stock-based portfolio. Probably not the best place to be, especially as you near retirement.
We used 8% in this analysis which I think is pretty fair and conservative.
Once you have your rate of return, you can project how close varying contribution levels will get you to your retirement goal.
