Tuesday, November 13, 2012

How Much to Save for Retirement – Part 1

When someone asks me how much they should save for retirement, they generally mean one of two things. Some mean to ask, “What is the total amount of savings I will need when I am 65 to maintain my pre-retirement standard of living?”

Others are actually asking how much of their paychecks they should be saving to accomplish the same.

Let me first answer both questions more honestly than probably anyone has responded in the past.

I don’t know. No one does.

There are too many unpredictable variables to make a guess with any accuracy, like how high interest rates will be when you retire, how much annuities will pay out and what the stock market will do between now and then. Then, there’s how much money you will be earning before you retire, whether or not you will be married, divorced, widowed or single and what financial setbacks you may suffer along the way. None of these is predictable with any accuracy and we would need to predict all of them.

As you get closer to retirement, these variables will become clearer, but from decades away, they are anything but.

Nonetheless, guess I shall. 

Let’s look at the first question, the total amount you will need to have saved by age 65 or so, and what various experts believe the answer may be. Remember that this is the amount of savings, in your 401(k) for example, you would need, in addition to Social Security benefits and other pensions, to maintain your pre-retirement standard of living after you retire.

Social Security Will Provide Part of Your Retirement Income

How much of your income will Social Security retirement benefits replace after you retire? The benefits are progressive. They replace more of your income if you are a low wage-earner than if you are a high wage-earner. Column two of the following table from an Aon Consulting report provides an estimate of the percentage of your pre-retirement income that Social Security should replace at various income levels.

For example, assume your income was $20,000 a year just before retiring and read the percentages from the first row of this table. Aon Consulting estimates that you will need to replace 94% of your pre-retirement annual income ($18,800) to avoid a decline in your standard of living after you retire. 69% ($13,800) will come from Social Security benefits and you will need to come up with the other 25% ($5,000) from personal retirement savings.

Retirement Savings Are Needed to Fill the Gap

Column three of the table above shows the gap between the income you will need in retirement (column 4 times column 1) and the amount that Social Security will provide (column 2). This is referred to as your shortfall.

Several financial experts have used estimates like this to calculate how much you would need to save by the time you retire to cover that income shortfall.

Table 1. Retirement Savings Needed in Addition to Social Security Benefits and Other Pensions to Maintain Pre-Retirement Standard of Living at Various Final Income Levels

Estimated Retirement Savings Needed
Income the Last Year You Work:
Ibbotson Guess
Aon Consulting Guess
AARP/Anne Thompson Guess
Money Magazine[1] Rule of Thumb

As I give you a minute to pick yourself off the floor, let me say that hardly anyone has actually saved this much. Only about 10% of all 401(k) accounts have balances of $200,000 or more. Half of Americans don’t have any retirement savings, at all, but that’s a topic for another post.

Also remember that the purpose of this blog is to help you make the most of retirement if you don't have enough saved.

Since these figures are so ridiculously different, I will offer an opinion that the best guesses are probably somewhere between Morningstar in column two and Aon Consulting in column three.

What Can We Learn from these Estimates?

At least these three things:

1. The fact that many experts calculate widely varying savings target amounts shows that the "correct" amount is incredibly difficult to predict.

2. No matter which expert is correct, hardly anyone will be able to save enough for retirement. These targets are much higher than the amounts most Americans have been able to accumulate for retirement since defined benefit pensions were converted to 401(k) plans in the 1980's. The typical 401(k) balance is about $78,000 today and, as I mentioned, fewer than 10% of those accounts are valued at $200,000 or more.

3. These are amounts we need to save in addition to Social Security benefits, so if those benefits go away or are significantly reduced, we would turn a ridiculously challenging savings target into a clearly impossible one. As you can see in column two of the table from Aon Consulting above, those savings targets assume that Social Security benefits will replace from about half (if you earn $90,000 a year) to three-quarters of your retirement income if you earn $20,000 a year.

You could calculate your own target savings amount by using these replacement rates and an estimate for your expected Social Security benefits. Here's how.

Sometimes, though, people who ask about how much to save for retirement mean, “How much each year?” Translating these estimates of how much you need to save in total to how much you should save each year to reach those totals is even more difficult and unpredictable, but I’ll address that in my next blog, How Much to Save for Retirement – Part 2.

[1] November 2012 issues, p. 70, “Savings Target 12 times income”.

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