Closing the Shortfall — How Much to Save for Retirement

How much money do you need to save for retirement?

Most retirees will pay for retirement with Social Security benefits and personal retirement savings they accumulated in 401(k) plans and IRA accounts. A few may have other sources of retirement income such as rental properties or a pension.

Author and investment adviser, William J. Bernstein, stated in the September 2012 issue of Money magazine that you should save 20 to 25 times your residual living expenses —  that is, the yearly shortfall you have to make up after Social Security and any pension.

The “shortfall” to which Bernstein refers is the cost of your desired retirement standard of living that Social Security benefits won’t cover.

If you need $60,000 a year after you retire to maintain your pre-retirement standard of living and Social Security benefits will provide $20,000, then you have a shortfall of $40,000 that needs to be met from personal retirement savings. If you don’t have enough personal savings to close that gap, your standard of living is going to decline, perhaps dramatically, once you retire.

There are four main factors in this equation to calculate the savings we need: taxes, annual retirement savings, expense reductions because you no longer work, and Social Security benefits. Let’s look at them one at a time.

The first factor is standard of living. We can start with your household income just before retirement. Let’s say you and your wife earn a combined $70,000 a year and plan to retire next year.  After you retire, you will no longer pay FICA taxes. Assume your pay stubs show that your wife pays $2,355 a year in FICA taxes and you pay $3,000, for a combined $5,355. You can subtract this $5,355 from $70,000 because FICA taxes don’t improve your pre-retirement standard of living. 

Your other federal taxes may decrease, too, along with state and local taxes. You should have your tax advisor calculate these taxes for your household before and after your expected retirement, but a 2008 study by Aon Consulting estimated these for various income ranges. I have included estimates from that report in the table below. The second row shows the percentage of your pre-retirement income you will no longer have to pay in FICA taxes after you retire and the third row shows an estimate of tax reductions in addition to FICA.

Data from Aon Consulting Study, 2008.

Aon estimates that taxes other than FICA will decrease 8.9% of pre-retirement income, saving $6,230 for a household earning $70,000 a year.

Retirement savings fall into the same category. After you retire, you will no longer need to save for retirement, right? Let’s assume you and your wife contribute a total of $4,000 (5.7%) to your company 401(k) plans.

I omitted Aon's estimates of retirement savings for the year before you retire because its easy and much more accurate to include your own actual savings rate. If you will save 5% of your pre-retirement income the year before you retire, for example, just add 5% to the percentage in the sixth row and subtract it form the percentage in the bottom row.

In our example above, if your income is $70,000 and you will save 5.7% of that amount the year before you retire, your Total Cost Reduction in Retirement would be 23% and your Income Replacement Ratio would decrease to 77%. On the other hand, if you were saving nothing for retirement that year, the percentages in the bottom two rows would be correct for your household.

The third factor, the reduction of your living expenses as a result of no longer working, is more difficult to predict because people do very different things after they retire. The Aon study, however, makes an attempt to estimate these and I have included them in fifth row of the table above. Note that for households with less than about $70,000, Aon estimates that these costs will actually increase. (See the study for their assumptions.)

Deduct 0.8% of $70,000 ($560) for expenses reductions and your $70,000 pre-retirement cost of living can now be purchased for $53,855 after you retire. Here's the math:

In our example, your replacement ratio, or the percentage of your pre-retirement income you must replace after retiring is about 83% if you aren't saving for retirement and about 77% if you are saving 5.7% of your pre-retirement income.

Note at this point that nearly all of your cost reductions in retirement come from lower taxes and no longer needing to save for retirement. Only a tiny part has come from the fact that your living expenses decline.

After calculating how our cost of living may change after we retire, the next factor in determining how much you need to save for retirement is how large your Social Security retirement benefits will be. You can get an estimate online at http://www.ssa.gov/estimator. Get estimates for both you and your spouse, if married. For our example, let’s say you learn that your combined Social Security benefits for your household will be $22,000 per year.

Now, we can calculate your shortfall, or how much of your pre-retirement income won't be covered by Social Security. Subtract the total of your Social Security benefits, or $22,000 in our example (31.4% of your pre-retirement income), from the cost of your after-retirement standard of living, or $53,855 in our example. Your shortfall is $31,900 per year in retirement, or about 46% of your $70,000 per year pre-retirement income.

Simply put, that means that you need to come up with an additional $31,900 a year after you retire to avoid a decline in your standard of living. 

The amount of savings you will need to accumulate to maintain your standard of living after you retire, according to Bernstein, is 20 to 25 times the amount of your shortfall.  For our example, you would need savings between $638,000 and $797,500 when you retire.

If you want to reverse the math and figure out how much you can spend each year of retirement for a given amount of savings, simply multiply the savings amount by 4% and 5% to get the endpoints of Bernstein’s range.

For reasons I will explain elsewhere, I use 4.5%.  For example, if you save a million dollars, you can spend about $45,000 a year from savings after you retire, though Bernstein would say you could spend between $40,000 and $50,000.

Our Broken Retirement System

The magnitude of the retirement problem America currently faces is difficult to comprehend.

Our retirement system is based on the assumption that the average Joe can save and successfully invest enough of his family's lifetime income in 401(k) and other retirement savings accounts to, with the help of Social Security benefits, maintain his standard of living after he retires. That requires accumulating at least hundreds of thousands of dollars of wealth in retirement accounts by roughly age 66, and perhaps a few million if your household income before retirement is six figures.

In the thirty years since the advent of the 401(k) plan and the beginning of the end of pension systems, few American households have been able to accumulate anywhere near those amounts.
The median value of a 401(k) account for someone approaching retirement age was recently $78,000.

Not millions. Not hundreds of thousands. $78,000.

Half of the retirees in the study — nearly 30 million American households— had no retirement savings at all. A lot of American households will simply drop out of the middle class when they retire.

Teresa Ghilarducci put it this way in a New York Times opinion piece entitled, "Our Ridiculous Approach to Retirement":

"The specter of downward mobility in retirement is a looming reality for both middle- and higher-income workers. Almost half of middle-class workers, 49 percent, will be poor or near poor in retirement, living on a food budget of about $5 a day."

Most Americans ages 50 to 64, 58 million of them in 2010, probably won’t have enough retirement assets to maintain their standard of living when they reach their mid-sixties, according to a 2012 study by the Schwartz Center for Economic Policy Analysis.

401(k) plans haven’t worked very well. Conservative talking heads love to say, "Boomers didn't save enough",  but it isn’t just Baby Boomers; Gen-Xers are even worse off based on their current 401(k) account balances. No generation has ever been asked to accumulate this much wealth and there is little reason to believe future generations will do better unless the system changes.

Will yours be one of the lucky households whose standard of living won't decline in retirement?

According to author and investment adviser, William J. Bernstein, you need to save 20 to 25 times your residual living expenses — that is, the yearly shortfall you have to make up after Social Security benefits and any pensions you might receive.

In it's simplest scenario, if you need $50,000 a year to maintain your current standard of living in retirement and Social Security benefits will cover $20,000 per year, your shortfall is $30,000. If that $30,000 is to come from your savings, you need 20 to 25 times that amount, or somewhere between $600,000 and $750,000 saved by the time you retire. If you don’t have enough personal savings to close that gap, your standard of living is going to decline, perhaps dramatically, once you retire.

The typical middle class American family approaching retirement has been able to save less than a quarter of what it needs to retire on, according to a study by the Center for Retirement Research at Boston College and reported in the Wall Street Journal in February 2011. That leaves most families highly dependent upon Social Security retirement benefits, which are meant to replace at most 30% of what you were earning before you retired.

For households that earn more, it will replace a smaller percentage. And that's at full retirement age, which is 66 for most people about to retire. Claim benefits at age 62 and they will replace perhaps 25%. So, figure on Social Security benefits replacing between a third and a fourth of your pre-retirement income.

What will it be like to live entirely off Social Security benefits? An article by Paul Sullivan in the New York Times in 2012 painted a picture. It isn’t pretty, but it’s what several tens of millions of Americans are facing.

Most people collecting Social Security benefits today have little or no other income.

Data collected by the Social Security Administration (SSA) from 2001 found that Social Security benefits provided more than half of the total income for almost two-thirds of retirement-aged households and provided at least 90% of income for a third of this group. That’s a lot of dependence on a benefit that is only meant to keep families off welfare.

The maximum annual Social Security workers benefit in 2012 is about $39,600 per spouse, but receiving a benefit that large would require that you paid the maximum in FICA taxes throughout your career (i.e., earned a lot of money) and that you delayed receiving Social Security benefits until age 70, when they max out. The average benefit is only $14,760 per individual per year.

So, the question you’re probably asking about now is, “How much money will I be able to spend when I retire?” For most households, the answer will depend on how large your (and your spouse’s) Social Security benefits will be and how much you have saved for retirement.

To answer the first question, go to the SSA’s website at http://www.ssa.gov/estimator/ and get an estimate of your retirement benefits and your spouse’s, if you are married.

The second question, “how much can I spend each year from my retirement savings?”, is a little more difficult. The answer will depend on how you choose to invest your retirement savings, but a ballpark estimate is 4.5% of your portfolio value on the day you retire. For example, if your retirement savings total $100,000 on the day you retire, you can spend about $4,500 from your savings annually and you can increase that amount by the rate of inflation each year. (Do not include home equity in your savings estimate.)

Here’s an example. Assume the SSA website estimates that you will receive $14,000 a year in workers benefits and your spouse is entitled to $7,000 a year in spousal benefits. The two of you have $100,000 saved in a 401(k) account. Your household will receive $21,000 a year in Social Security benefits and can spend $4,500 from savings. You can spend a total of $25,500 a year after you retire.

This is an estimate. There are steps you can take to increase your retirement income and mistakes you can make to decrease it. I will discuss those in future blog entries, and I cover them in my book, Retiring When Your 401(k) Fails.

(For a more detailed explanation of calculating the shortfall, see my post entitled, "Closing the Shortfall — How Much to Save for Retirement.")

Unless your pre-retirement earnings were relatively low, you probably need at least a quarter million dollars in retirement savings to avoid a decline in your standard of living after retirement. If a quarter million bucks sounds like a lot to save, keep in mind that it will only support about $11,250 of retirement spending per year (4.5%). Savings of $78,000 will support spending of about $3,510 a year.

Don’t be surprised if the income you calculate for your household in retirement is disturbingly low. For most households it will be. As I said at the beginning, most households haven’t been able to save nearly enough for retirement and Social Security benefits don’t go very far.

If you have saved enough, then give yourself a pat on the back. You succeeded where the vast majority of Americans have failed. If you failed, you have lots of company and winning this game is always a long-shot.

The American retirement system doesn’t work, except for the very lucky and the very wealthy, as a lot of households are about discover over the next few decades. I can't fix the U.S. retirement system, but I can help you make the best of a challenging situation. Please drop by my blog frequently for more information. (Oh, and did I mention my book, Retiring When Your 401(k) Fails?)

In future blogs, I’ll discuss some of the things you might do to improve your financial situation in retirement.

Don’t expect miracles, though. There are no easy answers.

The Basic Structure of Retirement Funding

While we work, we pay Social Security taxes (part of FICA) into a Social Security "account" and we save for retirement in a 401(k) or other type of retirement account. There is no actual Social Security "account" with our name on it, but there is a record of our earnings and of the FICA taxes we pay that will determine the amount of our Social Security benefits one day. Our employers withhold about 7.5% of our paycheck for FICA. About 6% is withheld for Social Security taxes and another nearly 1.5% is withheld for Medicare.

Our 401(k)s and IRAs are real accounts with real funds in them that we can withdraw at anytime. However, withdrawals made before age 62 are subject to taxes and penalties except under special circumstances. Our retirement savings accounts grow through more savings contributions from our paychecks and by investing our savings in assets we hope will grow in value, like stocks and bonds.

After we retire, our job income stops but the bills continue. We receive Social Security retirement benefits based on how much we paid in Social Security taxes. If we are able to accumulate retirement savings, we can spend about 4% to 4.5% of our savings total on the day we retire every year. This amount, added to Social Security benefits, will provide nearly all retirement income for most households.

For example, if we will receive $14,000 a year in Social Security benefits and have $100,000 in savings on the day we retire, we can spend $14,000 plus 4% of $100,000, for a total of $18,000 per year.

S&P 500 Returns for 30-Year Periods Before and After Inflation

Over various 30-year periods, the U.S. Stock market has had a fairly broad range of average returns. Depending on when your 30-year career began, the market could have returned between less than 3% and nearly 10% per year on average.

Average market returns are mostly irrelevant when applied to your retirement plan. If you are born 25 years before a great bull market you have an opportunity to make money in the stock market. If your working career spans a long bear market, your investment returns will be paltry.

Like it or not, your lifetime market returns depend largely on the accident of your birth date.

30-year Rolling Stock Market Returns

The largest factor for successfully accumulating wealth for retirement by investing in the stock market is the accident of when you were born. If you turn retirement age after a great 30-year run of stock market gains, you stand a better chance of funding your retirement. Workers who planned to retire in 2009, on the other hand, “picked” a poor year to be born. Their stock portfolios fell 30 percent, 40 percent or more at the very end of their careers.

The table below shows that if you were fortunate enough to be born in 1940 and turned retirement age in 2005, the last 30 years of your career saw the market gain 1,015 percent. But, if you were born just three years later in 1943 and retired in 2008, the market gained only 530 percent over the three decades before you retired.

If you were born in 1925 and retired in 1990, you saw the stock market gain only 256 percent over 30 years. Talking about being born under a bad sign!

Rolling 30-Year Investment Returns

30-Year Period	Average Annual Market Gain	After Inflation %	Total 30-yr Gain
1975-2005	13.1 %	8.4 %	1015 %
1974-2004	11.9 %	6.9 %	636 %
1950-1980	11.2 %	6.6 %	580 %
1978-2008	10.6 %	6.3 %	530 %
1954-1984	10.3 %	5.5 %	404 %
1952-1982	9.9 %	5.4 %	384 %
1956-1986	9.5 %	4.6 %	284 %
1960-1990	9.5 %	4.3 %	256 %

Long Term Care Insurance

Insurance companies often quote scary statistics like “Nearly two-thirds of Americans over the age of 65 will require long-term care” and “Long-term care can cost over $75,000 a year.” Both statements may be technically correct, but they distort the reality.

Consider the full set of statistics, as reported in a paper entitled “Long-Term Care Over an Uncertain Future: What Can Current Retirees Expect?” by Peter Kemper, Harriet L. Komisar And Lisa Alecxih, for example, and a more complex picture appears. According to this paper published in 2005:

• 43 percent of people turning age 65 will have no private out-of-pocket costs for long-term care, at all

• 19 percent will have costs less than $10,000

• 8 percent will have out-of-pocket costs between $10,000 and $25,000 over their lifetime.

• 14 percent will have costs from $25,000 to $100,000.

• 11 percent will have costs over their lifetime from $100,000 to $250,000.

• Only 5 percent will have costs of $250,000 or more.

While nearly two-thirds of retirees will, in fact, require Long Term Care (LTC), some of this care will be provided less expensively at home and not all stays will be catastrophically long. The average stay will be three years, with one year at home and two in an LTC facility.

These estimates tell us that most people (61%) will be able to afford to pay for long-term care services out of pocket with no more than modest hardship.

Still, 5 percent of Americans turning age 65 will need to pay potentially catastrophic long-term care costs of $250,000 to $600,000 or more. A complete retirement plan has to consider the possibility that we will fall into that unfortunate 5 percent.

If you have $1M or more in retirement savings ($2M for a couple), you may want to consider self-insuring instead of purchasing LTC insurance. If you cannot afford LTC premiums, you will have no choice but to go the Medicaid route. If you fall in between those ranges of savings, the choice will be more difficult.

Typically, a low-probability risk of a potentially catastrophic loss is a prescription for insurance, and long-term care insurance is available. Nearly all LTC insurance, however, is found lacking in several respects and the decision to purchase that insurance is not always obvious.