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Post #8 – Retirement Planning Simplified, Part II

This blog post will provide a simple guideline to estimating what your personal annual savings rate should be in order to reach your retirement nest egg goal.  This post is a follow-on discussion of the 4-step process I discussed in my last post, Post #7. If you have not done so already, you should read Post #7 before reading this post.

The final step to complete a quick assessment of your retirement planning is to determine how much you should save each year to reach your retirement savings goal estimated in Step 4 of Post #7. I have read much information on this topic. The best guidance I have found, that is also simple to apply, is a table contained in the 2005 book Yes, You Can Still Retire Comfortably!: The Baby-Boom Retirement Crisis and How to Beat It written by co-authors Ben Stein and Phil Demuth. An updated version of the table they presented in their book is provided below. The figures are based on several assumptions such as, a conservative, well balanced portfolio, a 1% investment fee paid, cost of living estimate based on 80% of your final year of earned income, retiring at age 70, no employer pension, and a few other assumptions. Some of these assumptions may turn out to be wrong for you, but I believe this table provides a reasonable guide for anyone who is just initiating their retirement savings plan and needs a starting point for their annual savings.

*Table reproduced with permission from Phil Demuth

To use this table you need your current annual salary (or total family earned income), your age (for couples use the highest age), and you need to know your current total retirement savings (this amount does not include your home equity, but it does include any equity you may have in any other property that is 100% dedicated to investment). The first step in using the table is you divide your current retirement savings total by your annual salary to determine your retirement savings multiple in relation to your annual salary. Once you have this figure, you look down the left hand “Savings” column to find your salary multiple. You then look across this row until you come to the column that corresponds to your age (or closest to your age). The figure at the intersection is the percentage of your annual income that you need to save each year for retirement. This table is based on retiring at age 70. If you want to retire at age 65, you simply add 5 years to your current age when using the table. The annual savings dollar amount indicated by the percentage of income is not a fixed amount; you must maintain this percentage as your income increases each year to allow for inflation.

A Simple Example

To illustrate the 4-step process in my last blog and the recommended savings rate table, let’s look at an example.  Ed and Betty are both 35 years old, each earning $50,000 per year ($100,000 combined income). They are looking to retire at age 65. For this discussion we will assume that they each are entitled to a $1,000 per month social security benefit. Neither Ed nor Betty expects to qualify for any employer pension benefit. Let’s also assume their current dedicated total retirement savings is $100,000.

In Step 1 we estimate Ed and Betty’s annual retirement living expenses by assuming it is 80% of their current annual income:

$100,000 x 80% = $80,000

In Step 2 we total Ed and Betty’s annual annuity benefits:

Ed’s social security benefit of $12,000 + Betty’s social security benefit of $12,000 = $24,000 per year

In Step 3 we determine Ed & Betty’s Net Annual Living Expenses (NALEs) that must be sustained by their retirement nest egg:

$80,000 minus $24,000 = $56,000

In Step 4 we estimate Ed and Betty’s retirement savings goal:

$56,000 x 25 = $1,400,000

From our simple 4-step process we estimate Ed and Betty’s retirement savings goal in current dollars to be $1,400,000.

To determine Ed and Betty’s recommended annual savings rate we start by dividing their current retirement savings amount by their current retirement savings of $100,000. The result is a multiple of 1.0. Since Ed and Betty want to retire at age 65, we add 5 years to their current age of 35. We look at the savings row in the above table and find the intersection at age 40. Ed and Betty’s required annual savings rate to retire at age 65 is 12% of their current income. In other words they should save 12% of their income each year to reach their nest egg goal at age 65. This 12% can include any matching funds from their employer retirement plan.

Some of you may look at this example and be thinking, “Man, $1,400,000 is way beyond my reach; I will never be able to reach even half that goal.” It is a lot of money, but it is achievable if market returns are near average and you are diligent in your savings plan. The $1,400,000 figure will need to be even higher when Ed and Betty’s retirement arrives 30 years from now. But over the 30 year time span, the market returns and inflation should approach their long term averages which mean the average “real return” (i.e., after inflation) will be around 4% to 5% per year allowing the couple to overcome inflation.

But it is a good thing if this big number gets your attention as most Americans are behind schedule on their savings and time is of the essence. Consider Ed and Betty’s situation described above. They are only 35 years old and, to retire at age 65, they will need to save 12% of their income for the next 30 years. 12% is an aggressive savings rate, but it is certainly doable without too much strain on the family budget. But what happens if the couple waits 5 years before getting serious about saving for retirement? According to the table (assuming no increase in their current retirement savings amount), their savings rate goes up to 20%. 20% starts to represent a real burden on their current income. What if Ed and Betty wait 10 more years until they are 45 years old to start their savings plan? The savings rate jumps to 34% of their annual income. We are now nearing the impossible zone for most families.

When I was 35 years old, I went through this exercise based on 80% of our current income and came up with some huge number like $3 million. My first thought was I am never going to make it without dramatically increasing my income. And I had an additional self-imposed requirement; I wanted to retire in my 50s and not in my 60s. This exercise caused my wife and I to do 2 things; first, we ramped up our savings rate dramatically. For the last 15 years before our retirement, we saved over 33% of our income (not including any corporate matching funds). Secondly, the analysis caused us to take stock of what was really important to us, and we trimmed our living expenses accordingly. We managed to trim our expenses to 50% of our final year’s earned income. This is another way to solve a huge savings deficit. You can decrease your planned living expenses. Think about it. If you are 50 years old with only 15 years left until retirement, is it easier to save another $300,000 or to reduce your retirement living expenses by $12,000 per year? You can always work longer but, as I stated in earlier posts, working longer is not a good back up plan as you may not have that choice available to you when the time comes. It is best to save early and often.

And there you have it; retirement planning simplified. The next logical question is how should you invest your retirement savings nest egg? I will provide a simple approach to this question in my next couple posts.

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