Saving money during your working years to ensure you don't run out of money after you retire is a very wise decision! So kudos to you for proactively planning for your future financial welfare. In this retirement planning guide, I will provide you with the education and insight necessary to calculate how much you must save for retirement to ensure your financial security.
Disclaimer: This article is educational and not advice. Please seek the council of a licensed professional before making any changes to your finances, to ensure they make sense for your unique situation. I am happy to help, or you can visit www.brokercheck.org to find an unbiased list of professionals.
What Does "Retirement" Mean To You?
In the past, many individual's definition of "retirement" was to discontinue working and relax at home with their family, who usually lived close by, and enjoy the simple things in life until they passed away. This was largely because of how short life expectancies were back then. According to the University of Berkeley, in 1950, the average life expectancy was only 65.6 for US males, and 71.1 for females. So you counted your blessings if you even lived to the current "full retirement age" of 67!
Today, due to advancements in medical care, a heightened focus on mental and physical wellness, and a general improvement in the quality of life, the average life expectancy according to the CDC has improved to 75 for males and 80.2 for females. In a best case scenario, you even have a decent chance of living beyond age 100, since the number of centenarians has increased 1,692% since 1950!
People are now living longer, healthier, and more active lives. Regularly enjoying retirements that last 10-15+ years beyond full retirement age.
This has completely changed the "retirement" paradigm: Instead of people retiring because they literally have to, due to old age and poor health, people are now retiring to enjoy more of the things in life they value, such as;
Spending time with their children, grandchildren, and even great-grandchildren.
Traveling around the country, and world, to explore and enjoy new experiences.
Pursuing an alternate career, or working as a consultant on a part-time basis.
Giving of their time and resources to support charitable and philanthropic causes.
So before beginning to work on your retirement calculation, take a moment to daydream and ask yourself: What do I want to do when I "retire"? Your answer to that question will greatly impact how much money you will spend.
How Much Will You Spend?
Unless you anticipate a major increase or decrease in your standard of living post-retirement, a great starting point for calculating the amount of money you'll need to comfortably retire and stay comfortably retired, is your current income. It's a law of behavioral finance that we have a strong propensity to spend all or most of whatever hits our bank account. Over time, our lifestyle spending just tends to calibrate to that amount.
If you are saving money in a "qualified" retirement account, like a 401k, then you will want to run your calculation based on gross income (before taxes). However if you are saving money in a "non-qualified" account, like a Roth 401k, you want to run your calculations based on net income (after taxes).
Determining net income is actually quite simple. Retrieve your most recent tax return and look for your "Adjusted Gross Income" (line 11 of form 1040), then find your "Effective Tax Rate" (Usually found on a summary or comparison sheet provided by your tax preparer), now subtract your effective tax rate from 100% and multiply your adjusted gross income by that number. Voila! Your net income.
Here's an example:
Adjusted Gross Income: $100,000
Effective Tax Rate: 21.5%
100% - 21.5% = 78.5%
$100,000 x 78.5% = $78,500 of net income
Now I hope you are not spending 100% of your income as that would be financially irresponsible and a recipe for consumer debt because you're flirting with disaster. If you're like most households, you're spending about 80-95% of that number. Therefore, decide about how much you feel you spend each month and multiply your net income by the appropriate percentage... Now you know your approximate current lifestyle spending!
For simplicity, we'll assume that your lifestyle (and thus it's effective cost) will stay roughly the same up to, and throughout your retirement. However, we can't simply use a multiple of that number to calculate your total retirement spending. We need to factor in the law of inflation, which says that everything we need and want to buy will go up over time (remember when milk was $0.50? And houses cost $100,000? Not anymore! That's because of inflation.).
Based on historical data, financial planners typically inflate the cost of living by 2.5% per year. So, take your current lifestyle spending and exponentially multiply it by 1.025 a corresponding number of times to the number of years you have until life expectancy, then total all the numbers after your planned retirement age. The resulting number is your total retirement spending.
Here's an example;
Husband and wife, both age 50
Current lifestyle spending of $70,650
Exponentially increased by inflation at 2.5% per year
Total retirement spending from age 65 to 81 = $2,134,926
That's a lot of money! But you probably don't want to risk running out of money by just having enough to reach life expectancy, because wealthy people tend to live longer due to access to better care in their sunset years. So that number should be the minimum. If you go out another 10 years to age 91, total retirement spending increases to $3,879,242... That is the number you should target.
While that may look scary, it is surprisingly manageable if you start saving an appropriate amount of money early enough, and invest it wisely. You'll also have support from the Social Security system, which offsets a significant amount (You can get an estimate of your potential Social Security payments here: Social Security Estimator). Now I know the solvency of the Social Security system is a controversial topic, but the unlimited taxing authority of the US Government is a substantial reason to plan on it. Whether or not you do is completely up to you. Just know that if you don't you'll need to save a LOT more.
Now that you've put a number on how much money you'll need to comfortably retire, the next thing you need to do is convert that to a practical amount, to routinely contribute to your retirement saving accounts.
How Much Do You Need To Save?
Calculating what percentage of your gross income you should be saving periodically is challenging because of several assumed variables. For the sake of demonstration, I'll use averages, but you'll want to give them serious consideration, given your unique situation.
Your "risk profile"
Your investment options
Your income frequency
Future investment returns
Future government policy
Your Risk Profile
Let's start with your "risk profile" (how much price movement you can mentally tolerate). When working with an investment professional who knows how to properly coach their clients, this is less of a concern, but when you're on your own it's a big deal because you won't have anyone to call when you get that "the sky is falling" or "I'm missing out" feeling.
Being invested in an asset class that aligns with your risk profile will [hopefully] prevent you from trying to time the market, which is disastrous to your success. The objective is be invested in assets that move within your "comfortable zone", so you'll stay invested.
There are many questionnaires and tools available online to help you assess your risk tolerance, but the concept is pretty simple. Just answer these questions to get an idea:
How much knowledge do you have about how investments work?
The better you understand what you own, and why it's price is moving, the more comfortable you will be with volatility (explained later).
How much experience do you have with good and bad market conditions?
Until you've actually experienced market euphoria and despair, you don't truly know how you'll behave.
In general; are you a risk-taker? Or more conservative?
Some people are naturally more comfortable with taking "leaps of faith", while others need assurance that they'll be okay. Look up your DISC profile.
Logically, because of the law of risk and reward, we should all be invested in the riskiest asset class for our time horizon, because they have historically produced the highest returns... but humans are emotional creatures who rely on their intuition when making decisions, so that would be unwise because you'd probably get scared part-way through and sell out.
You'll notice that two of the three questions listed can be improved. The last questions is pretty fixed. You're not going to change your personality. But you can put time and energy into studying how different investments work, and what factors drive price movement. Also, over time, you will gain more experience with various market conditions. That is why your risk profile evolves and most people buy "riskier" investments over time.
Your Investment Options
Now that you know your risk tolerance profile, you can look for asset classes that fit your profile and time horizon. There are many types of investments, but for simplicity's sake, we'll just consider some common cash-equivalent, fixed-income, and equity options.
Cash-equivalents (typical long-term returns: 0% - 2%)
Bank accounts (checking, savings, etc)
Money market instruments (CD's, government notes, etc)
Cash-equivalents are for absolute preservation. Barring a major catastrophe, you won't lose anything, but they produce very low returns.
Fixed-income (typical long-term returns: 1% - 4%)
Fixed-income is for when you need to create a predictable stream of payments. They are good for preservation, dependent upon on the issuer of the bond and the length of the term, but the total return is pretty low.
Equity (typical long-term returns: 6% - 12%)
Ownership of companies (equity) can be for creating income or seeking appreciation, or both at the same time. Preservation varies and is entirely based on the reliability of the company. Expected returns from equity ownership is based on the industry, size, and focus of the company you own. Here are some examples:
A growth-focused tech company would be expected to grow significantly over time, but not distribute dividends for a long time. (typical long-term returns: 10% - 12%)
A large established company would only be expected to grow moderately, but distribute of their profits as dividends. (typical long-term returns: 8% - 10%)
A utility company would not be expected to grow much, but should generate a lot of consistent income. (typical long-term returns: 6% - 8%)
How this all ties together with your risk profile, is volatility, which is a measure of the magnitude of the price swings of an investment (called standard deviation). In the examples below, comparing the volatility of bonds with growth companies, you can clearly see the difference. While the growth companies have produced significantly higher returns vs bonds over the period, it has been a much bumpier ride with some scares along the way.
This may all seem unnecessary, but to calculate your saving rate, you must know what your expected return is, and that is dependent on what you're invested in.
Let's run an average scenario based on;
Male, age 50
"Moderately aggressive" risk profile: 10% return
Already has $150,000 in a 401k
Plans to retire at age 67
Social Security at FRA: $62,860
Life expectancy: 90
Total retirement spending: $5,197,508
Here's the process:
Years to retirement (17)
Years to life expectancy (23)
Total retirement spending (exponentially multiply $100k by 2.5% for 17 years, then another 23 years, then total the 23 year range: $5,197,508)
Total Social Security (exponentially multiply $62,860 by 2.5% for 23 years and total the range: $2,033,461)
Total retirement spending minus Social Security ($3,164,047)
Use algebra to solve for X in this equation: $150k + X per year, compounded at 10%, accumulates enough money in 17 years, to sustain 23 years of withdrawals, grossed up for taxes.
Convert that number to a percentage of gross income.
Result: 11% of gross income.
I realize that was super confusing and complicated. So I made a spreadsheet for you: Retirement Planning Calculator
The only thing that never changes, is that everything changes. Therefore you should routinely revisit your calculation to ensure it is still accurate given your current financial situation and government policies.
Over the years, you will experience many "Critical Financial Events" that will alter the factors which make up your calculation, and political parties will come and go, changing tax policy as them move along. Your investment performance is also likely to be much different from what you calculated, hopefully for the better.
Here are a few examples to emphasize the fact that things change:
You or your spouse get a promotion or new job and start earning 15% more per year. Chances are high that your lifestyle will adapt over time. You'll become accustomed to this higher level and need to adjust your calculation to accumulate significantly more money. Or, you could save the extra money and recalculate to retire earlier.
The government changes tax bracket thresholds and you move up, or down, one or two brackets, paying 10-15% more, or less, taxes. You'll need to recalculate to account for higher or lower withdrawals in the future (if you're investing inside a qualified account), or higher or lower contributions today (if you're investing inside a non-qualified account).
After some additional education and experience, you feel comfortable taking "riskier" investments that will hopefully earn higher returns. Or, after a market downturn, you realize you don't have the stomach to stay invested through tough times. Either way, you'd need to recalculate based on where you are currently invested, and plan to invest, over time.
The Social Security Administration changes the calculation formula, significantly reducing benefits to retirees younger than a certain age, which you are. You'll need to recalculate with higher withdrawals now that Social Security will be contributing less to your retirement income.
Recalculating ensures that you stay on track no matter what happens.
Plans without action are worthless... Now that you have the education and insights to do your retirement planning, DO IT! Otherwise you'll run out of money, or have to reduce your standard of living in retirement. Take action today and reap the rewards in the future.
Also, there's probably someone you know that would benefit from reading this article too! Share it with them, help your friend, and make the world a wealthier place.
Hire A Professional
If after reading this guide, you would rather not have to run the numbers and monitor the financial world, or you would like an experienced third party to help your family answer the planning questions, ask a licensed professional to assist you. Most financial advisors and planners do what they do because they want to help people, and you should get more value from their service than you pay. It's a very wise investment.