If you are a goal-oriented person, set a target for your retirement savings. Some people need goals. If you’re one of them, establish a target amount of wealth to accumulate.
Or, you can look at the Savings-Spending Dynamic, our special analysis of the tradeoff between savings and spending. This concept shows you approximately how well off you'll be in retirement based on the percentage of your current earnings you save. Use it to find your own personal savings-spending level . The more you spend now, the less you’ll be able to save, and the harder it will be to maintain your current lifestyle in retirement. Conversely, the more you save now, the less you’ll spend on current lifestyle, and the smaller the amount of retirement savings you’ll need to maintain your less expensive lifestyle in your golden years. This dynamic—spending less now allows you to save more while lowering the amount you need to save—leverages your ability to fund your retirement. If you want a retirement income (including Social Security benefits) somewhere around 70% of your average annual earned income, save about 12.5% of your earnings. If you want a good chance of retiring without loss of lifestyle, save at least 20% of your earned income.
Max out your contributions to retirement accounts like 401(k)s and IRAs to get their tax sheltering effect. But don’t assume that these accounts will be enough for the retirement lifestyle you want. The contribution limits for these accounts are simply the amount of tax benefit Uncle Sam gives you. You may or may not need to save more, depending on your retirement goals, how long you save, and how you invest.
If your target amount seems so high you feel doomed to fail, forget the goal, save as much as you can, and declare victory when you retire. It’s not unusual to be told that you must save at least $1 million, $2 million or more for retirement. Many people can’t believe they will ever accumulate that much money, and don’t bother to save at all. That’s a big mistake. If the goal is scary, bag the goal, and simply save as much as you can. You’ll end up wherever you end up but it will be better than nowhere. Don’t cheat on saving, because you’re only cheating yourself.
Whatever your goal, don't be greedy. Greed kills financial plans and wrecks futures because it leads you to take reckless risks. We want to help you build wealth, but being greedy isn't the way to get there.
When it comes to retirement planning, having a goal may help. Some people, those who are goal-oriented--are more likely to achieve something—such as a specific amount of retirement savings—if there is a target for them to aim at.
How much should you save? That depends on how much you think you’ll need. One often hears that a retired person needs about 70% of his or her pre-retirement income. Or else, 80%, 90% or even 100% are claimed to be better targets.
Let’s see what it takes to save enough to provide 100% of your income in retirement. We’ll assume that you and your spouse have a combined household earnings of $100,000 a year, and that you and your spouse begin collecting a combined total of $25,000 a year from Social Security at your full retirement ages (65 to 67, depending on when you were born). We’ll also assume you have no pension. That means that your savings have to provide $75,000 a year. It’s a generally accepted rule of thumb that, if you retire around age 65, you’ll need savings equal to 25 times the amount of the annual retirement income you want in order to have enough money to last your lifetime. Multiplying $75,000 by 25 yields $1,875,000. Note that this number is not adjusted for inflation.
How much would you have to save to get to $1,875,000? To do our calculations, we used the savings calculator available at http://cgi.money.cnn.com/tools/ to derive estimates of the needed savings levels; other useful financial calculators are also available at this site. If you and your spouse both have tax-deferred accounts like 401(k) accounts, you’d have to save about $20,000 a year for 30 years, assuming your investments yield a return of 7% per year, compounded annually.
That’s $1,667 a month, or 20% of your pre-tax monthly earnings of $8333. We use a 30-year period for wealth accumulation because most people don’t get serious about retirement planning until their 30’s, or even later, and the most time they’ll have to save is about 30 years. Can you save this much?
Some people have employers that match a portion of the contributions they make to 401(k) accounts. In other words, the employer contributes a dollar for each dollar you contribute, up to a specified limit. (See our discussion of retirement accounts for more details.) If we assume one-fifth of the savings going into these 401(k)’s consists of matching funds provided by employers, you and your spouse still have to come up with $16,000 a year, or $1,333 a month. That would be about 16% of your monthly pre-tax earnings. If you’re lucky enough to have an employer match (and most people don’t), could you save this much?
If you start in your mid-20’s and save for 40 years, you’d have to put away about $800 a month (which could all be in 401(k) accounts) to get to a total of $1,875,000 in your mid-60’s. That’s a lower level of saving (demonstrating the power of compounding), but how many 25-year olds have $800 a month (i.e., $9,600 a year) to put into a retirement account? Or, if one-fifth of the amount was funded by an employer match, even $640 a month (or $7,680 a year)? The theoretical value of saving for 40 years doesn’t mean much if you don’t have the cash to save.
Saving enough to provide 100% of your income in retirement—20% of your income for 30 years--isn’t easy. Can you afford to set aside 20% of your current earnings? The burden of saving that much makes you wonder whether you’ll really need 100% of your pre-retirement income when you enter the golden years.
There are a couple of other ways to approach the problem of defining a goal. You can crunch numbers, or you can use our own proprietary concept: finding the right personal savings-spending level.
Crunching numbers can give you a better sense of how much you would need to save for a comfortable retirement. After one retires, work related expenditures decrease, while the costs of retirement activities increase. A retired person will not have to spend money on work clothing, commuting, professional training and education, or $4 cups of coffee during mid-morning and mid-afternoon breaks. He or she will also not pay Social Security taxes or make contributions to 401(k) plans any more. On the other hand, a retiree may spend more on golf course dues and fees, travel, hobbies, gifts for grandchildren, and fishing tackle. And the infirmities of old age begin to crop up, so medical expenses will rise. Therefore, not all of the savings from ceasing to work go to the bottom line. So, how much should you save?
Start with your monthly expenses. Not your budget, but your actual spending—don’t cheat here because you’d only cheat yourself. To calculate your expenses, look at your checking account monthly statements and credit card monthly statements, and add up the total spending you are doing. If you pay off your credit card balances every month, you probably need to look only at your checking account statements. (If you are spending other assets, like an inheritance or your home equity, add that in as well.) Don’t include amounts that are saved; we’re talking about spending here. Review 6 to 12 months, and calculate a monthly average. Most people have greater expenses in some months than others, so using a number of months is important to getting an accurate average figure. Then subtract the costs of commuting, work clothing, workday lunches, café lattes, and all of your other work-related expenses. If you think you’ll be able to pay off your mortgage and home equity debt paid off by retirement, deduct those expenses as well. (Be honest with yourself about the mortgage and home equity debt—overestimating your retirement expenses is a much less serious mistake than underestimating them.)
Then add in reasonable estimates for retirement expenses, such as medical care, travel, hobbies, sports, etc. Medical care can be a whale: the costs of Medicare B, Medigap policies for you and your spouse, Medicare Part D prescription drug insurance, and normal out of pocket expenses can run up to $10,000 a year total (that’s $800+ a month); and you haven’t played a single round of golf yet. The result will be the estimated level of expenses you need to cover. Let’s assume that you estimate you’ll need $4,000 a month, or $48,000 a year, in retirement. Since this is the amount you think you’ll spend, this is what you’ll need after taxes. Additional income is necessary to cover taxes.
Most people (i.e., those in the middle income brackets) pay about one-quarter to one-third of their income to cover federal, state and local income taxes. Of course, the amount of tax depends on how much income you have, what deductions you might take (assuming you deduct) and where you live. People who don’t have to pay a state income tax may have lower retirement expenses as a consequence (although low or no state income taxes may be offset by high sales or property taxes). To be conservative, let’s assume that you will pay state income taxes, and that your combined state and federal income taxes are 30% of your income. To calculate the pre-tax income you’ll need for retirement, take the after-tax income you want and multiply it by 1.4 (a factor that reflects the assumption that you’ll pay 30% of your income to cover federal and state income taxes). Our hypothetical calculation of $48,000 a year after taxes multiplied by 1.4 yields a pre-tax income of $67,200 a year.
Next, we'll estimate the amount of Social Security you can expect (including whatever amount your spouse will receive, either as your spouse or as a result of his or her earnings history). Let’s assume for the purposes of this example that the total amount is $20,000 (which is around the average for a couple in retirement). That leaves a gap of $47,200 a year. If you or your spouse will receive a pension, subtract that amount from the $47,200 a year. However, the viability of many pension plans is increasingly unpredictable (ask airline employees for details). We will be conservative and assume you have no pension. If you count on a pension, and find out fifteen years later that the pension has been greatly reduced, you will have lost fifteen years in which you could have saved more. Caution is in order. (Okay, it’s not fun to live life defensively, but living it recklessly has a high correlation with dog food in your retirement diet.)
Thus, your target is to accumulate enough money to provide $47,200 a year. What will it take to do this? Let’s apply the rule of thumb mentioned earlier (which assumes you’ll retire at age 65) and multiply $47,200 by 25. The result is $1,180,000. Thus, you’ll need financial assets worth around $1,180,000 for your retirement.
How would you get there? As we have noted, many people don’t get serious about saving for retirement until they are in their 30’s. That gives them about 30 years to put together a retirement portfolio. Other people who start saving earlier may, because of layoffs, forced retirements or other unexpected events, also have no more than about 30 working years to build their retirement portfolios. Using a 30-year working life, and assuming that you can save in a tax-deferred account like a 401(k), you’d have to save about $12,500 a year. We assume that your investments yield 7% per year, compounded. (Since this saving occurs in a tax deferred account, we don’t take your current tax situation into account; but if you were saving in an ordinary taxable account, you’d have to factor in the cost of current taxation as well.)
Note that we have not factored in the effects of inflation. That is an important issue. However, incomes increase roughly in line with inflation for most people and each year you should increase the amount of your retirement savings in line with inflation. This will go a long way to adjusting your retirement savings for inflation. If you follow this strategy, you should end up with a much larger dollar amount of retirement savings than $1,180,000 that, hopefully, will be enough to keep with the much higher costs of living.
You may be familiar with the limits on contributions to the retirement plans known as 401(k) plans, which in 2009 and 2010 are $16,500, and $22,000 if you’re 50 or over. There are smaller limits for IRAs, which in 2009 and 2010 are $5,000, and $6,000 if you’re 50 or over. The contribution limits for retirement plans don’t necessarily have anything to do with the amount of money you’ll need in retirement. They are just the amount of the tax break Uncle Sam will give you for retirement savings. Even if you contribute the maximum amount permitted by the tax laws, your retirement may be under-funded. If you want to ensure that you reach a particular level of financial security, calculate the amount based on your personal needs and wants, not based on the amounts of contributions allowed by the tax laws for retirement accounts.
If you don’t like to wallow in arithmetic, but want to figure out how much to save in order to prevent your income from dropping off a cliff after your retire, take a look at our analysis of the dynamic between saving and spending. This concept is based on a simple idea: the more you save, the less you spend on current lifestyle and the less you'll need to maintain your current lifestyle in retirement. A good saver will have a less expensive current lifestyle in order to have a better future. This confers an important advantage: with a less expensive lifestyle, you’ll need less money to maintain that lifestyle in retirement, yet will have more resources to save for retirement. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle. In other words, by controlling your spending today, you leverage your ability to save for a comfortable retirement.
To illustrate the point, if you’re spending 100% of your current income, you’ll save nothing for retirement, and your retirement income will nosedive to the level of just Social Security benefits. Study up on dog food brands; maybe taste test a few.
If you spend 95% of your earned income, and save 5% in a 401(k) account—adjusting your contributions upwards annually for inflation--you’ll have a decent sized nest egg after 30 years (assuming annual investment gains of 7% compounded). It will be enough to let you, at age 65, start withdrawing from your nest egg an amount equal to about 19% of your average annual pre-retirement income, assuming you’ll draw down 4% of the initial value of your retirement assets per year in retirement. (Go to our discussion of making money last in retirement for more detail about the ins and outs of drawing down your portfolio in retirement.) Adding that 19% to your Social Security benefits may not sound like a lot, but it’s a damn sight better than zero.
If you live on 90% of your earned income and save 10% in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income. This assumes you retire at age 65 (use the 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d have enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today makes it easier to save for a retirement lifestyle closer to what you're used to having. To see how these numbers work at various levels of saving, take a look at the following table.
| Current Spending (% of earnings) | Current Savings (% of earnings) | % of Current Earnings at 65 from Ret. Savings | % of Current Spending at 65 from Ret. Savings |
100% |
0% |
0% |
0% |
| 95 | 5 | 19 | 20 |
92.5 |
7.5 |
28 |
31 |
90 |
10 |
38 |
42 |
| 87.5 | 12.5 |
47 |
54 |
85 |
15 |
57 |
67 |
82.5 |
17.5 |
66 |
80 |
| 80 | 20 |
76 |
95 |
77.5 |
22.5 |
85 |
110 |
75 |
25 |
94 |
125 |
Using the information in this table, you just add in your likely Social Security benefits (look at your annual statement from the Social Security Administration) and any pension benefits you might get. The total figure will give you the likely retirement income you'll have.
We assume that you’ll save for 30 years in a tax-deferred account like a 401(k), increasing contributions over time for inflation, and get a 7% yearly return compounded annually. We further assume that, in retirement beginning at age 65, you’d draw down 4% of the initial value of the retirement portfolio per year, adjusted in subsequent years for inflation. The numbers in the table are not engraved in stone. There’s a bit of rounding involved. And if we change the assumptions—such as having some of the saving in a taxable account, using a lower yearly return or working with a shorter time frame for saving, like 20 or 25 working years—the numbers will change (requiring a higher level of saving). But you can get the basic idea from this table.
From the left, the first two columns show various levels of saving. The third column from the left shows how much of your current earned income your retirement savings would provide annually, assuming you retire at age 65. The column farthest to the right shows how much of your average annual living expenses your retirement savings would provide. This is the key column. It reveals how you can maintain the standard of living you had during your working years. As you can see, the higher the percentage of your earned income you save, the easier it will be to maintain your standard of living in retirement.
The table shows that if you save 10% of your earnings for 30 years, you’ll end up with about 42% of your pre-retirement living expenses. Next, you should add in your Social Security benefits. Look at your annual statement from the Social Security Administration to find out how much your benefits are likely to be. Add Social Security benefits to this 42%, and, if you’re middle class ($40,000 to $100,000 a year), you could end up with something around 60% to 70% of your annual pre-retirement living expenses. You’d have to cut back some on your spending, but you’d be okay. If you’ll qualify for a pension, add that amount in as well, and you’ll get an even better picture. But be careful about relying on a pension. For many people, the promise of a pension has proven illusory. Early retirement, employer bankruptcy or other unforeseen circumstances can reduce an expected pension. You don’t have to take our word for it; talk to airline employees or former Enron employees. Financial self-reliance is rarely a mistake. Don’t worry about over-saving for retirement; if you do, you’ll just be punished with a lot of caviar and champagne in your golden years.
If you save 15% of your earnings for 30 years, and add Social Security benefits, you’ll probably have a retirement income pretty close to your average annual pre-retirement living expenses. (Keep partying.) If you save 20% of your earnings, and add in Social Security benefits, you’ll have a good chance of ending up with a higher standard of living in retirement than you had on average during your working years. (Turn up the volume at the party.) Save 25% of your earnings, add in Social Security and you could end up retiring quite high up on the hog.
It’s important to note that these numbers are for your average annual earnings over the course of your working life. Your average annual earnings for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off low and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher percentage than the above table indicates. At least 20% of your earned income would be a good idea.
What if you don't have 30 years to save? Many, and perhaps most, people don't have fairy tale lives. They don't settle into one job or even one career and steadily work away for 30 years. Career changes, time off to raise kids, moves from one city to another to accommodate a spouse's job change, layoffs and numerous other circumstances disrupt lives. Many people have only part of their adult lives to prepare for retirement. To help them understand the choices they have, we present two additional tables. Other than the shorter window of time for saving, they have the same assumptions as the 30-year table above (i.e., that you'd save in a tax-deferred account like a 401(k), increasing contributions over time for inflation, and get a 7% yearly return compounded annually; we further assume that you'd retire at age 65, draw down 4% of the initial value of the retirement portfolio per year, and adjust in subsequent years for inflation).
The first is for 25 years of saving.
| Current Spending (% of earnings) | Current Savings (% of earnings) | % of Current Earnings at 65 from Ret. Savings | % of Current Spending at 65 from Ret. Savings |
100% |
0% |
0% |
0% |
| 95 | 5 | 13 | 13 |
92.5 |
7.5 |
19 |
21 |
90 |
10 |
25 |
28 |
| 87.5 | 12.5 |
32 |
36 |
85 |
15 |
38 |
45 |
82.5 |
17.5 |
44 |
54 |
| 80 | 20 |
51 |
63 |
77.5 |
22.5 |
57 |
73 |
75 |
25 |
63 |
84 |
The next is for 20 years of saving.
| Current Spending (% of earnings) | Current Savings (% of earnings) | % of Current Earnings at 65 from Ret. Savings | % of Current Spending at 65 from Ret. Savings |
100% |
0% |
0% |
0% |
| 95 | 5 | 8 | 9 |
92.5 |
7.5 |
12 |
13 |
90 |
10 |
16 |
18 |
| 87.5 | 12.5 |
20 |
23 |
85 |
15 |
25 |
29 |
82.5 |
17.5 |
29 |
35 |
| 80 | 20 |
33 |
41 |
77.5 |
22.5 |
37 |
48 |
75 |
25 |
41 |
55 |
These last two tables demonstrate that you can get somewhere even if you start saving later in life. It's not quite as advantageous as starting early. But if you save 15% of your earned income for 20 years, you have a good chance of getting retirement income of almost 30% of your average annual pre-retirement spending level from savings. Add in Social Security benefits, and if you're middle class, you could end up with retirement income of a bit more than 50% of your average annual pre-retirement spending level. While that wouldn't buy a yacht, you'd probably be okay. If you can save 20% of your earnings for 20 years, you would have a good chance of reaching two-thirds of your average annual pre-retirement spending level after adding in Social Security. That's probably enough to feel comfortable. The people who really lose out are the ones who don't save at all.
Our special analysis of the Saving-Spending Dynamic lets you set a retirement savings goal without having to use a somewhat arbitrary percentage of your current earnings or do a lot of arithmetic. If you fit the assumptions underlying the table (20, 25 or 30 years to save, investing in a well-diversified portfolio, increasing the amount saved each year for inflation, etc.) you can choose from the continuum of options presented in these tables. Of course, our Saving-Spending analysis is just an approximation that is based on a variety of assumptions. It can only give you a general idea of the relationship between saving and spending, and how far you get depends on many individual decisions you make. But you now have a simple framework for thinking about your choices. Just pick the level of saving that seems right for you. It's easy, and, here at Uncle Leo's Den, it's free.
What’s the right level of saving? That's your choice. Everyone has a point where the trade-off between saving and spending feels comfortable. Your personal saving-spending comfort level won’t be the same as the next person's. Our analysis shows you the tradeoffs. Pick a point along the continuum that works for you. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would fall in the range of less lifestyle now and more diet-busting cruises later. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. The table may indicate that 15% will get you there, but 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is possible since go-go years in the stock market like the late 1990’s are often followed by long periods of below average gains).
If you have fewer than 30 years, save more or be prepared for a less lavish lifestyle in retirement. If you have fewer than 20 years, just save like crazy and declare victory when you retire. A savings level of 25%, 30% or more of your earned income would be advisable if you want to have something significantly better than life on Social Security.
Note that we speak of saving percentages of your “earnings” and “earned income” because you have to base the saving-spending equilibrium on your earned income; your investment income is part of the compounding growth of your assets and doesn’t count for this purpose.
Now that you understand the saving-spending dynamic, decide where your personal comfort level is.
Many, and perhaps most, people, would believe that they can’t accumulate $500,000, $1 million, $2 million or more. For them, finding $1,000 a month for retirement savings is like searching for water in a desert without a map. Even if we optimistically assume that a fifth of that amount comes from an employer match for contributions the employee puts into the 401(k) account, saving even two-thirds of that amount would require $800 a month from one’s own salary. If only money grew on trees . . .
Another problem is that layoffs, periods of unemployment, career changes, staying at home to raise children, serious illness or injury, divorce, a child with special needs, or an elderly parent who needs expensive care can all disrupt a retirement savings plan. Most people don’t have fairy tale lives, and their ability to save will vary over the course of their working years. When times are hard, they cut back on saving. If times are really hard, they tap into their retirement savings—a bad idea, but if the refrigerator is empty there may be no other ideas.
It’s only human, when confronted by a seemingly impossible goal, not to bother at all. Trying to achieve the impossible only sets you up for failure, and many people may avoid saving for retirement because they think they’ll fail. That’s why we don’t believe that establishing a target is all that important. It may actually discourage many people from trying. If you are discouraged by the size of your supposed retirement goal, or are hit by one of life’s unexpected downturns, forget the goal, save as much as you can, and declare victory when you retire. This is not the ideal way to prepare for retirement. But if you acquire the habit of saving and investing, you’ll probably do okay in the end. Just close your eyes and shove as many nickels as possible into the piggy bank. You never know when a layoff, forced retirement, illness or other setback will hit, so save while you’re making money. Keep building wealth as and when you can. Don’t look for excuses not to save; you’ll only shortchange yourself.
Whatever you do in terms of a goal, don't be greedy. Greed kills savings and investment plans, because it leads people to become reckless and take on too much risk. It's important to be rational and reasonable in your goals. Don't fall for get rich quick schemes. If you want too much, you could end up losing, not winning. Instead, follow our investment guidelines and try to control your risks by laying a solid financial foundation, while seeking reasonable returns using one of our model financial plans.
As part of the process of building wealth, you have to control the risks of losing your wealth. You face personal risks--like layoffs, health problems, or liabilities from car accidents and other mishaps--and investment risks. For ideas about how to handle these risks, please go next to our discussion of personal risks.