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How much to save for retirement

2020-04-03, Michael Thompson

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How much to save for retirement

Studies indicate that over half of workers fail to estimate their retirement needs until their 60s, leading many to delay retirement or live an overly frugal retirement. Why not spend a few minutes now to better understand how much you need to save for retirement?

A simple rule of thumb provided by most experts is to save 10 to 15% of your pretax income for retirement. For example, saving 10% of your income in your 401K and having an employer that matches half that would hit the target. We independently crunched the numbers and agree with this, but the uncertainty in future investment returns, inflation and individual's unique scenarios make this a very rough estimate.

There are some important points we’d like to make about this estimate. First, it does not include savings for buying a home, taking a vacation, child education, etc. All those things would be in addition to this. Next, this is for a specific scenario – a person that starts saving at 25, retires at 65, and expects to live about 80-85 years with comparable disposable income in retirement. If you start saving later or plan to retire earlier, you’ll need to save a higher percentage. If you pay off a house or otherwise have reduced expenses in retirement those would of course reduce your savings needs. If your government will provide some sort of social security that could further reduce your savings needs. Later we'll discuss other scenarios and how much those should impact your retirement savings.

This rule of thumb may seem unrealistic to many younger adults who are trying to pay off college debt with low-paying jobs. A recent survey indicated that more than 60% of Americans are behind on retirement savings. There are ways to catch up later in life, but if you can make compromises now that's probably better. Check out this article for tips on living a more frugal, happy lifestyle. For example, a fancy car is often one of the worst places to put your money!

How much have you saved so far? This rule of thumb should provide you with savings equal to your annual salary by age 30. After that, you should save an extra annual salary every five years. For example, you should have 2X your annual salary saved at 35, 3X at 40, …. If you’re behind, one strategy recommended by experts is to save an additional 1% each year. If you saved 9% last year, then try to save 10% this year, 11% next year, …. We recommend saving as much as you can without robbing yourself of happiness, until you've caught up to these amounts. With compound interest, the sooner you get money invested the better! The IRS allows for catch-up contributions to your retirement account in some cases. At the time of this writing, you must be at least 50 years old.

Don’t panic if you’re behind on savings. Even if you fail to reach “appropriate” savings by retirement, it doesn’t have to spoil your retirement. Study after study shows that money, while helpful, is not crucial to happiness. If he has enough money for nutritious food, a man with healthy relationships with friends / family will generally be much happier than an isolated man with 10 Lambos in his garage.

In the rest of the article we’ll discuss the assumptions in these estimates and how different scenarios impact your required savings. For the upcoming decade experts expect roughly 7% annual returns on equities, 3% on bonds and 2% inflation (i.e. investment returns below what we might expect from recent years). We'll use these values for all subsequent calculations. We'll assume a 25-year-old is starting with (1) 0 savings, (2) earning 85k USD/year, (3) saving 15% (of pre-tax income) for retirement, and (4) receives an average raise of 3% per year. We'll assume she invests 100% of her savings in equities until age 45. At age 46 and every year thereafter she moves 4% from equities to bonds (8% bonds at 47, 12% at 48, ... until she holds 100% bonds at age 70).

If this individual retires at age 65, she will have about 3M USD saved for retirement. That may be more than you expected, but realize that, at this point, she's consuming almost 235k USD/year (this is after 40 years of inflation). If she maintains this disposable income, adjusted for inflation, she will run out of money at age 79. This is assuming she receives no social security support and continues her pre-retirement spending (adjusted for inflation). In reality, spending may go up or down significantly during retirement due to factors like living in a house that’s already paid for, no longer supporting kids, traveling more frequently, ….

How much does this change if she saves 10% annually (instead of 15%) for retirement? Under the same assumptions as above, she will retire with about 2M USD and run out of money before age 74. If she has good genes, she'll likely need to cut back during retirement, and not have the ability to provide a safety net for younger loved ones.

What if she saves 20%? In this case she’d retire with over 4M USD and have enough money to reach age 83. What if she works until age 70? In this case she’d retire with 2.5 / 3.8 / 5.1 M USD when saving 10% / 15% / 20%, and she’d run out of money at age 80 / 84 / 89. What if she retires at 60? In this case she’d retire with 1.5 / 2.3 / 3.1 M USD when saving 10% / 15% / 20%, and she’d run out of money at age 67 / 71 / 77.

You may want to try other retirement calculators, e.g. at Nerd Wallet. For other views on this topic see The Balance, Fidelity or Vanguard.

Related Retirement Notes

We've done these calculations assuming that you manage your investments and draw from them in retirement. While this is fine for estimating savings needs, it's not the best approach for most people. Using some or all of your savings to purchase a retirement annuity is often a better option. These hedge against your risk of outliving your money - they provide regular income until your death. We can't get into many details here, but be sure to do your homework and / or get help before purchasing an annuity - there are some ripoffs out there. Checkout Dr. Wade Pfau’s work if you want to learn more about annuities and selecting the best option for yourself.

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