Are you Saving Enough for Retirement? Check Out This Rule of Thumb

Are your retirement savings going to be enough for you to live comfortably during your golden years? A while back, Money Magazine published some great guidelines, aimed to help you answer that $64,000 question. Before we get to the guidelines, though, it is important to understand that they are built on a number of assumptions.

First, they assume you will need to replace 80% of your current, pre-tax income during retirement. If you make $100,000 now, for example, you’ll need $80,000 of pre-tax income per year during retirement. Second, the guidelines assume you will receive about $20,000 a year in social security benefits. If you would like an estimate of your social security benefits, check out this social security benefits calculator.

Third, the assumption is that you won’t receive any pension benefits (a good assumption for most of us). And finally, the guideline assumes that your retirement savings will grow by 8% a year during retirement, and that you will withdraw 4% per year to live on.

In the above example, you’ll need to replace $60,000 of income ($80,000 – social security benefits of $20,000) with your retirement savings. At a 4% withdrawal rate, you’ll need to amass $1.5 million by the time you retire ($60,000 / 4% — or if you hate division, $60,000 * 25). The 4% withdrawal rate has become a fairly accepted conservative estimate of how much you can take from your retirement savings if you want your money to last 30 years. Using a 4% withdrawal rate, simply multiply how much money your savings will need to pay you each year by 25, and you have the amount you’ll need in savings at the time of retirement.

 

Now at this point you may be asking why the chart started at 45. What about the Gen X kids? Having recently learned that I’m a member of Gen X, not a Boomer (barely), I feel obligated to cover the younger crowd. It turns out that this chart comes from Charles Farrell of Northstar Investment Advisors. Mr. Farrell wrote a paper back in 2006 that went into much more detail about how much savings (and debt) you should (and should not) have at various stages of your life. The complete chart from his original paper is to the right. He’s also written a detailed book on the subject, called Your Money Ratios.

You’ll note that the chart starts at age 30. You may also note that the Savings to Income ratio beginning at age 45 is different than what Money Magazine listed. So, what’s going on?

This is an important point. In Farrell’s original paper, he assumed a 5% withdrawal rate; Money Magazine assumed a 4% withdrawal rate. And if you think just 1% is no big deal, think again. At 4%, you need 15 times your pre-retirement income ($100,000 in our example) at retirement to produce 60% of this amount (remember social security covers 20%). But at a 5% withdrawal rate, you “only” need 12 times current income. In our $100,000 hypothetical, the difference in retirement savings is $1.5 million versus $1.2 million.

Which assumption is best? I don’t think there is a best here. Four percent is more conservative than five percent. The logic behind the 4% rule is that you will earn 8% a year with a relatively conservative mix of stock and bond investments. Four percent stays in savings to keep up with inflation, and 4% comes out to pay for your living expenses.

So, seeing what you make now and what you think you will need to live comfortably later on… are you saving enough for retirement?

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