There’s a nice little book that recently came out by Teresa Ghilarducci called How to Retire with Enough Money: And How to Know What Enough Is. It’s short, at 116 pages, and it avoids a lot of the fluff to get to the heart of the answer that a lot of people are wondering: How much should you save for retirement?
Why should you listen to her? She’s a professor of economics, and she has spent her career studying the economics of retirement. She was also a presidential appointee to the Pension Benefit Guaranty Corporation, which insures traditional pensions for 40 million workers, along with a host of other credentials that tells me, “Okay, you know what you’re talking about.”
Let me condense the most important points for you.
1. To answer the above question: the average person will need eight times their annual salary in retirement accounts.
2. In retirement, you’ll need 70%-80% of your pre-tax, pre-retirement income, and that 70% figure assumes you’ll have paid off your mortgage by the time you retire.
3. Social Security will replace 40%-50% of pre-retirement income for middle-class individuals, and for those with higher incomes who earn more than $118,500 per year, they’ll get 29% or less from Social Security.
Your objective is to have enough saved so that 80% of your pre-retirement income can be replaced by the annual withdrawals from your savings. And to make your savings last to perpetuity, it has generally been recommended that you withdraw at most only up to 4% per year from your total balance.
So if you’re making $100,000 per year before retiring, let’s assume that Social Security will replace 30% of your income ($30,000/year), leaving you to make up the other 50% ($50,000/year) with savings (remember, we are aiming for 80% of your pre-retirement income).
So how much would we need to save to earn $50,000/year from our savings if we’re only allowed to withdraw up to 4% per year?
$50,000 divided by 4% is $1,250,000.
But hey, $1.25 million isn’t eight times the $100,000 annual salary! Good catch, that’s right. That’s 12.5 times, which is great if you can get there (by the way, the author is aiming for 15x). But that also assumes you’re trying to make your money last forever and that your investment portfolio will earn on average 4% per year to offset the 4% annual withdrawals.
Now if you’re not planning on living forever, you can take more than that 4%. If we assume your investment portfolio earns 4% per year, the math suggests you can take out up to 6% per year in order to make it last 18 years (assumes that you do the spending first (which grows by a 3% inflation rate), then it grows your balance by the 4% rate of growth).
Is 18 years enough for retirement? The average life expectancy according to the Social Security Administration is 84.3 for a man and 86.6 for a woman and most retirements last an average of 18 years. If you retire at the “full retirement age” (FRA), which is 67 for people born after 1960, that would seem like a reasonable figure, but you will have to determine that for yourself, and nobody knows for certain how long they’ll live, so you may want to adjust that withdrawal rate lower or higher depending on how long you expect to live.
But back to the math. If we withdraw 6% from our portfolio and need $50,000/year from it, that means we should have about $830,000 saved up, which is close to the eight times that the author stated should be our target.
Now let’s resume the condensed important points from the book:
4. The longer you wait to take out Social Security benefits, the larger your payout. Your maximum payout is reached if you can wait until you turn 70. Your payout at age 62 is 43% lower. Your payout at full retirement age is only 20% lower. It pays to wait, plus you benefit from having a nice income from your current job along the way.
5. Live modestly and try to live on 70% of your income now.
6. Pay off your debt (especially credit card debt!) and make extra payments on your mortgage to take years off your payment schedule.
7. Stick with low cost index funds for your investments, and stay diversified. Don’t ever pay sales commissions, and hire fee-only, fiduciary investment advisors, who will help you avoid products with high fees.
8. Take advantage of employer matching on your 401(k)s to accelerate your savings growth.
And I’m adding this one myself: Save 15% of your monthly paycheck, and if you’re not there now, do it the next time you get a raise so you don’t feel it.
So that’s it. Eight is the magic number you need to aim for, at the very least. And for a more refined approach that reduces the ambiguity of your future even further, you may want to have a financial plan created so you have a detailed road map for where you will be financially X-number of years in the future with a high degree of certainty. We will be discussing financial plans in an upcoming post.
Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
Investment Risk Disclaimers: (i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results.