Contributed by John E. Rice, CFA, CFP®
Will you have enough money to retire? Whether you hire professionals to help with your financial planning or do it yourself, you need to tackle this question if you are going to have a successful financial life. Because of what I do for a living I get asked for investment advice quite often. If the person seriously wants to have a conversation about their finances then I ask them a simple question.
“Have you sat down and worked through the calculations to see if you will have enough money to meet your financial goals?” Because if not, then all the investment advice in the world is not likely to result in success.
I get a variety of answers but most have not done these calculations. One guy explained his retirement plan as follows. “Well…if I run out of money I guess I can always be a greeter at Wal-Mart.” Working through your retirement years may be one option but let’s try to avoid that through some very basic planning.
How much you save is the single biggest factor in your retirement equation. There are other important pieces, such as what investment vehicles you use (tax deferred, Roth or taxable) and what you actually invest in (growth or income investments). But most people underestimate the importance of the basic savings rate and overemphasize the other pieces of the investment decisions.
So how much do you need to save? A good rule of thumb for a younger person is to allocate 20% of your income to savings. You are likely to desire a lifestyle in retirement that is similar to the lifestyle you enjoyed during your later working years. If you save 20% each year during working life, and invest it for growth, you should be able to accumulate a nice nest egg by the time you retire to support spending throughout your retirement.
You have to make assumptions to run this analysis. Let’s say you are age 35 now and you plan to retire at age 65. Let’s also say that you expect to live for 30 years in retirement to age 95. We also need to assume a growth rate for your portfolio and we will assume 6% for this analysis. Additionally, we will also make the assumption that you receive Social Security during your retirement and husband and wife together get $20,000 annually in Social Security benefits.
Let’s say you require $200,000 per year in retirement including your tax payments. Some people won’t need that much and others will need more but the math works in ratios. A couple that has a retirement cash flow need of $200,000 was probably earning $250,000 or more during the years up to their retirement. If they were saving 20% then they were putting away $50,000 per year during these last few years.
However, they would not have been earning this income when they were age 35. To make the case more realistic we should assume they were able to save $20,000 at age 35 and then $1,000 more per year until they reached a savings level of $50,000 around age 65 at the end of their working life.
If this money is compounded at 6% per year it would grow to approximately $2,400,000. If they then started to withdrawal funds at a rate of $180,000 and continued to earn 6% on their investment portfolio they would spend down their retirement savings throughout the years and it would just about last to age 95!
So the 20% rule works in this case. But what if you are older and just starting to save? Or what if you don’t earn a 6% rate of return on your investments? In some cases you may not realistically be able to get to a retirement level that is close to your last working years, but you may not need to if your mortgage is paid off and you reduce your expenses.
So if you are trying to figure out how you will ever be able to retire, the most important piece is how much you save. You should earmark at least 20% of your income each year for retirement savings. You should also address two other components of your retirement plan but neither is as important as how much you save. One is which investment vehicles you use in your plan. Should you save in Roth IRAs, tax-deferred accounts, or simple taxable accounts? The other decision is what investment selections you should make within your accounts. Most people that approach me say they want growth but can’t afford to lose any money. As the old Frank Sinatra song says, “You can’t have one without the other.” It is important that you invest in some growth assets because of the compounding effect, and you may experience losses if you invest for growth.
But start with the savings decision. Each year you can do a very simple calculation to see if your household is hitting this 20% or more savings target. If you are getting a later start your target may need to be higher. By keeping this simple target in your sights each year you can achieve a successful retirement.