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How much should you save for retirement?
Posted on October 4, 2024

If you are in the Save and Invest phase of life, how much should you be contributing to your retirement plan? Are you on track for a successful retirement? I’ve looked at several retirement calculators and they’ve confused me. I built a spreadsheet that says that you will have a happy retirement if you (and your employer) contribute 10% of pay to retirement plans. That has two critical assumptions: 1) you start (or started) early – at age 25; 2) you invest (invested) correctly – in low cost, broad-based, stock index funds. If you don’t or didn’t take those two actions, you’ll need to save 15% or more for the same end result.

 

Details:

 

== At the start of retirement ==

 

Let’s work back from the point that you retire – when you leave the Save and Invest phase and enter the Spend and Invest phase of life. You want a portfolio that – along with Social Security – AT WORST CASE provides a total after-tax income for the rest of your life that is very similar to what you spend in the years near retirement. Patti and I would not have wanted to start retirement thinking that we should spend  less than did when we were working.

 

You may be able to figure out how much you want to spend in retirement; I found this very difficult to do before we were retired and plan or retirement that way. I had to use the steps in Nest Egg Care (NEC) to get to our Safe Spending Amount (SSA, see Chapter 2, NEC): does Social Security and my “pay” (SSA) from our nest egg get me to an income level that I like. If I did not like the answer, I would have been in the category of the “Disappointed Duo” in Chapter 5, NEC and would face some tough decisions.

 

You may be able to judge what you want to spend in retirement. You can use the bottoms-up approach. I might use this top-down shorthand: I’d use 85% to 90% of your peak (or recent average) pay near retirement as the “total pay” you want in retirement. You won’t be paying 7% to SS; you won’t be saving up to 10% for retirement plans. All other taxes will be about the same.

 

WORST CASE means we have to use the logic in Nest Egg Care (NEC): you have to assume you will face THE Most Harmful sequence of stock and bond returns in history when you are retired. Making that assumption drives to a low but Safe Spending Rate (SSR%, Chapter 2, NEC) that ensures you will NOT OUTLIVE YOUR MONEY. That Most Horrible sequence (It started in January 1969.) is the fastest to deplete a portfolio for a given “spending rate” – that’s a constant dollar withdrawal amount for spending per initial portfolio value (e.g., 4.2% SSR% is $42,000 per $1 million investment portfolio; constant dollar means the amount adjusts for inflation each year; you always have the same spending power each year.

 

You want MORE portfolio value at that point in time: that amount drives all income – your Safe Spending Amount – that you’ll get from your investment portfolio for the rest of your life.

 

== What income do you want? ==

 

The amount you need is driven by the amount you want to pay yourself from your portfolio.

 

I assume in the spreadsheet that you get a real 3% pay increase from your initial job for 25 years and level off from age 50 to 65. That results in final, acceptable pay that’s about double your first year pay, measured in  the same spending power.

 

That would have been acceptable to me: I remember my first pay at age 23 and I would have been happy with double that in spending power that when I switched to the Spend and Invest phase 47 years later: when I inflation adjust that amount for another 10 years to now, that number is ~20 times my first annual salary.

 

== Eventually: 14 times your final pay ==

 

Your portfolio needs to provide the amount that’s in addition to Social Security. In my example, I assume Social Security provides $40,000 of your acceptable pay. I assume your Safe Withdrawal Rate (SSR%) is 4.2% at age 65 (Life expectancy of ~22 years from the Social Security Life Expectancy Calculator; see Appendix D, NEC for the SSR%). The math works out that you need a portfolio that is ~14 times your desired annual pay. If you want retirement income that equates to $125,000 of wages in today’s spending power, you need a portfolio that is $1.75 million in today’s spending power.

 

== You need to save 10% ==

 

We can find the savings rates that accumulate to 14 times final desired pay: you need to consistently save 10% of pay starting at age 25. (That’s your and your employer’s contribution rate.) You need to invest solely in stocks: I assume 6.8% real return rate over the 40 years that you will be contributing; I’m being a bit conservative relative to their 7.1% long run average return rate.

 

• You must start in your 20s or you will have to save much more later to get to the same end result.

 

The first five years years will equal 25% of the total that you will have at the time of retirement because of the power of ~four decades of compound growth. The last 20 years – from age 45 to 65 – also contribute about 25% to the total.

 

If you contribute nothing before age 30, the required contribution rate jumps to 13% for all years.

 

• You must invest solely in stock index funds to keep ~all that the market returns. If you invest in bonds and higher expense ratio and fees that lower your net return by one percentage point, you will have to save 30% more – 13% savings rate – for the same result.

 

• If you don’t start until you are 30 and you invest to earn one percentage point less than from stock index funds, your saving rate has to be 15%. That’s 5% of pay that you can’t enjoy now: you can’t afford to be sloppy about this!

 

== Milestones over time ==

 

I can plot how much you should have accumulated over time relative to your income. This is assuming a consistent return rate, and we know returns will vary. But I think these are useful benchmarks.

 

 

I met with my niece this week. At age 48 she and her husband have more than twice the guideline. Their portfolio is more than eight times current pay vs. the benchmark of 3.8. (She, in particular, saved like the devil when she was younger and invested only in stock index funds.) They are headed to a retirement that will AT LEAST be twice their working income!!!

 

== Likely much better later ==

 

You will almost certainly NOT experience the Most Harmful sequence of return when you retire. You will be able to recalculate to a greater real Safe Spending Amount (Chapter 9, NEC). Patti and I experienced ~50% greater SSA in the first seven years of our retirement plan. Our total “pay” in retirement is greater than when we worked. If my niece and husband, in worst case, head to retirement “pay” that is twice their current pay, they could be at three times current pay when they are in their 70s.

 

 

Conclusion: I find a number of retirement calculators for those in the Save and Invest phase of life that confuse me. I built a spreadsheet that I understand. I calculate you (and your employer) need to save 10% of pay to have a happy retirement: the ability to spend at the level of your highest earning years. It is critical to start or to have started in your 20s; the first five years compound to about 25% of the total you will have at age 65. You also must invest solely in stock index funds. If you don’t follow those two, you’ll need to save closer to 15% per year. That added 5% is money that you can’t use to enjoy now.

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