What Percentage of Our Income Must We Save For Retirement?
In previous articles I discussed the historic range of outcomes for a saver undertaking a DCA program, and what sort of IRR they could have expected, especially if they had been willing to delay retirement for up to 5 years if necessary.
As I also mentioned, my analysis is an oversimplification. The two main flaws are that we cannot assume the past will repeat itself, and I only looked at the S+P 500.
Assuming we include a wider array of asset classes that might help to increase our returns, such as small and value stocks, developed and emerging international markets, etc., we can adjust our assumptions up a bit. However, assuming that we hold a decent amount of our portfolio in bonds, and that returns might be lower going forward, we would adjust back down again.
Just as an exercise, lets say we use an estimated real IRR of 4.5% over a 30-year savings timeframe, then how much do we need to save to make it to retirement?
The first question to answer is how much income would our retirement portfolio provide? The oft-heard dictum that a 4% withdrawal rate is sustainable probably doesn’t translate anymore, so lets assume 3%. That means the portfolio should be about 33 times as large as what we want to take out of it each year going forward.
While social security is uncertain for people many years from retirement, lets say that it can replace 20% of your salary. Of course this will vary widely, and the number will be substantially less for the very affluent.
Further, I am going to assume that a person’s salary is flat in real dollars over this 30-year timeframe, which again, is not always accurate. I will define their income as their salary minus what they put away for retirement. Are we talking about gross or net salary? Well, if you’re putting your income into a traditional IRA or DC plan, you should be thinking in gross salary. If you are using a Roth vehicle, you are thinking in net salary.
I tend to think that once people hit retirement, they probably don’t need as much income as they did before. Hopefully they’ve paid off their mortgage, the kids are out of the house, college is out of the way, and for whatever other reasons their bills are a bit lower. I’ll define post retirement income needs as 90% of pre-retirement levels.
Now have our parameters. I won’t bore you with the math I used to find my answer, but I’ll show you an example to verify it.
Lets say our salary is $100,000. Here’s the punch line, the savings rate will need to be a little over 25%. So each year we save $25,000. That means the income we live off of is $75,000. In retirement we’ll only need 90% of that, but then we need to knock another $20,000 off the number to account for social security. Finally, we can multiply that number by 33.33 to get the required size of our nest egg. By using these round numbers your nest egg should be $1,583,175.
Now, check the answer with a basic financial calculator. One further note, I am assuming the contributions come at the start of each year. 30 periods, 4.5% interest, $25,000 payment, and the future value comes to be $1,525,177, so we are pretty much there. And remember from the previous article, if you want this plan to have a high degree of certainty, you need some timeframe flexibility. Your 30-year plan might actually take 35 years.
If you can plan for 35 years the rate can be less than 21%. Say you only have 25 years to save? The necessary savings rate jumps up to 31%. 20 years left? 38%. And that doesn’t account for the fact that shorter savings timeframes give less certain results with a wider range of possible outcomes. I was using the same 4.5% IRR, which is probably a bad idea. Do not try this at home.
Of course, you could change around some assumptions and get some radically different numbers. However, I tend to think that promoting a 12-15% savings rate, as many people do, is flat wrong. You might get there, but I wouldn’t count on it.