How Much Money Do I Need to Save for Retirement?
Topics: 4% Rule revisited, Problems with the 4% Rule, 15% savings rate, Saving and compound effect
In my last blog I asked the question: How Can Effective Asset Management Help Me Reach Financial Independence?
I enjoyed writing that last post – maybe it gave us all something to dream about – achieving FIRE. I wrote it first because it does provide some inspiration for me in daily life. It makes me contemplate today’s choices as I think about how I can either reduce expenses (now or in the future) and increase passive income – or both - as part of my overall Asset Management strategy. Maybe it can become reality but most of us are still working toward retirement in some form or another. We try to save, but other things come up to distract from our retirement savings plan. We sacrifice for our kids, or maybe our spouses, or even our parents or extended family. We often put the needs of others first and subsequently come to the realization that at some point we won’t physically be able to work, and now we question what retirement would even look like. The bad news is that while you can finance almost anything you want, you can’t get a loan for your retirement. The good news is that it’s never too late to start saving. Maybe now you’re wondering what your next steps are. Or what your current net worth is, or what your retirement plan looks like. If so, we should get together – email me: firstname.lastname@example.org.
On a personal note
As for me and my plan, we use software to determine the probability of achieving our goals (and we can do that for you too!), but being an excel nerd I still have a projection for my net worth over every quarter for the next 30 years! (yes, feel free to LOL). I did this because I previously worked in a world of forecasting. All about the numbers and using all publicly available information to create a model to use to form an opinion on an investment. The joke used to be that whatever number you forecasted (let’s say we project next year’s company earnings of $1 per share), you knew that was NOT what it would be. Too many things change. Too many variables. But if you look backward to understand how the company operates and use similar assumptions going forward, you could generally minimize your error. And no one anticipates the surprises, so you “hope” for more good news than bad news. Applying this personally, I know my spending habits, I have a budget, so putting it all together I created my 30-year projection. I absolutely know the number 30 years from now WILL NOT be what I have calculated, but if I continue to save and invest like I have in the past and take advantage of opportunities, then there’s no reason I can’t be in the ballpark. And I can live with that.
Moving on, a couple pretty good rules come to mind when contemplating retirement. I addressed them both in my last post: the 4% rule and a 15% savings rate (credit to Fidelity).
4% Rule revisited
This rule for retirement suggests you can withdraw 4% of your portfolio for living expenses in retirement and adjust the actual dollars with movement in your portfolio. It’s not as simple as finding an asset that might return 4% and living off the interest it would generate because inflation negates probably half your return. The study conducted by William Bengen in 1994 looked at historical data and found that statistically at any point in his research (dating back to 1926) an individual could withdraw 4% of her portfolio every year and not outlive her money (for 30 years). Doing the math backward, if you make/spend $100,000 a year, you will need a portfolio of $2.5 mil. to maintain that lifestyle. Yes, you won’t be putting aside savings for retirement while in retirement, but perhaps you will be traveling more or giving more to charity or to your family members, which is why many advisors might match your pre-retirement spending levels to your post retirement spending levels (and to make the math easy), but the average consumer often spends less in retirement.
Problems with 4% rule
In the last few years, more industry pundits have talked negatively about the 4% rule. If you go back further in history than the original study (to 1900 instead of 1926) then about 5% of all scenarios resulted in outliving your wealth. If the study was applied outside the US, the chances also increased, and considerably. Furthermore, when this study was conducted in 1994, we were in a much higher interest rate environment, meaning income generated from the bond assets in your portfolio delivered substantially higher returns than they can today. And lastly there is concern that the 4% rule would actually cause you to live too conservatively (?!?) – a good problem I suppose – so at least your descendants and favorite charities would benefit. There’s obviously no guarantee that the next 30 years will look like any of the previous 30-year periods, but the fact remains that historical data generally supports the 4% rule as being pretty effective.
15% Savings Rate
In our last post we reintroduced the idea put forth by a study from Fidelity that saving 15% of your total pre-tax income might be the right number to reach retirement depending on several factors including career length, when you start saving and relying on social security income. The assumption is that you start at age 25 and work and save until age 67 (I assume because that’s when you would be eligible for “full retirement” per social security – if born after 1960). The study also suggests people spend 55-80% of the pre-retirement income in retirement to maintain their lifestyle, so factoring in social security, your “nest egg” needs to be able to generate about 45% of your pre-retirement income. All that adds up to saving 15% of your pre-tax income – and for a long-time. If you follow our 50/30/20 rule we suggested here, a 20% savings rate would presumably get you there faster.
Examples to Contrast Savings Rate – MATH TIME!
Many employers offer a 401k match, often around 3% (some could be much higher, and some don’t match at all). I’ve previously stated the minimum you should direct toward your 401k is enough to fully receive the company match, implying a 100% return. So, let’s assume you make $125,000 a year and contribute your 3% to get the company match. You are saving $3,750 a year or $312.50 per month. While that’s a great starting point, continuing that level of savings for 30 years and assuming a 7% return would result in a nest egg of slightly over $380,000 (not factoring in company contributions for this example). That’s a decent amount of money but applying the 4% rule (withdraw 4% of $380,000 in year 1 of retirement) implies living expenses of just over $15,000 a year! That probably won’t cut it if you have been making $125,000 per year (that’s just 12% of your previous income).
On the other hand, the IRS stipulates the maximum amount you can save this year in your 401k is $19,000. That equates to roughly 15% of our $125,000 salary (not coincidentally). Saving this amount monthly ($1,583.33) for the next 30 years (and ignoring the fact that the IRS typically increases the amount allowed to save annually) at the same 7% return would be more than $1.9 million! Again, using the 4% rule, you would then be entitled to more than $76,000 per year or living expenses of more than $6,000 per month, or 60% of your previous income.
Of course, we are ignoring taxes in this example, but the implication is that a 15% savings rate is a good starting point compared to the minimum. Even still you will need to rely on other sources of income (social security, passive income, etc) and/or lower your expenses in retirement to match income and expenses.
This exercise got me thinking about savings rate and the difference between the dollars you actually set aside compared to the impact of the compound interest you get over time.
So our final example to illustrate the value of saving (sorry if you don’t like numbers, but I like numbers). If I save $100 a month for 5 years and it compounds at the same 7% rate, I put aside $6,000 ($100 x 12 months x 5 years) that is now worth $7,159. So, my interest enriched me by $1,159 ($7,159 - $6,000), representing 16% of the value after 5 years. This is great, but the vast majority of the value comes from actually saving.
The next question I had to ask myself in this example is at what point would the value of the compound interest gained equal the value of my contributions? Well that comes in YEAR 18! At that point you would have contributed about $21,600 and gained an equivalent amount in interest (approximately). My point then is that you have to put away significant dollars – and for a long time. The compound effect works in your favor, but it takes a long time to become relevant and is so much more valuable over a significantly long period.
So in summary, you need to be saving – and not just the minimum, but significant dollars and do so regularly. And if you’ve gotten off track due to life’s circumstances, find a way to get back on track. Saving isn’t a one-time event. The best way to achieve wealth is consistent saving and investing (dollar cost averaging). If you think a financial advisor, or anyone for that matter, can make you a millionaire under normal risk considerations, it’s not likely. I believe the true path to wealth is saving your money and investing it wisely over the long-term and in a regular pattern because you can’t know what surprises the market or economy or life will bring. You can’t know how long you might be able to work or what may happen as you wait for retirement. The one thing you can do is save money. The 4% rule and a 15% savings rate are at least some rules of thumb that can at a minimum provide guidelines. Our plan is to focus on slow and steady saving, constantly evaluating unique opportunities, and keeping our investing costs low. We suggest you do the same.
If you or someone you know has any financial-related questions, I would love to have a conversation, so please feel free to contact me here.
Please don’t forget to view our prior blogs:
And stay tuned for our upcoming post on college planning, as well as additional blog posts on retirement savings and other topics.
Best wishes on your financial path!
This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.
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