What Percentage Should You Save

What Percentage Should You Save?

One of the key questions facing investors is “What percentage should you save of your income?” People like a quick rule of thumb, and so you will often hear “10%” as an answer. This is an easy round number, a mental shortcut, and feasible for most people. Unfortunately, it is also a sloppy, lazy, and inaccurate answer. 10% is better than nothing, but does 10% guarantee you will have a comfortable retirement?

I created a spreadsheet to show you two things. Firstly, how much you would accumulate over your working years. This is based on the years of saving, rate of return, and inflation (or how much your salary grows). Secondly, how much this portfolio could provide in retirement income and how much of your pre-retirement salary it would replace.

The fact is that there can be no one answer to the question of what percentage you should save. For example, are you starting at 25 or 45? In other words, are you saving for 40 years or 20 years? Are you earning 7% or 1%? When you change any of these inputs you will get a wildly different result.

10% from age 25

Let’s start with a base case of someone who gets a job at age 25. He or she contributes 10% of their salary to their 401(k) every year until retirement. They work for 40 years, until age 65, and then retire. Along the way, their income increases by 2.5% a year. Their 401(k) grows at 7%. All of these are assumptions, not guaranteed returns, but are possible, at least historically.

In Year 1, let’s say their salary is $50,000. At 10%, they save $5,000 into their 401(k) and have a $5,000 portfolio at the end of the year. In Year 2, we would then assume their salary has grown to $51,250. Their 401(k) grows and they contribute 10% of their new salary. Their 401(k) has $10,475 at the end of Year 2.

We continue this year by year through Year 40. At this point, their salary is $130,978, and they are still contributing 10%. At the end of the year, their 401(k) would be $1,365,488. That’s what you’d have if you save 10% of your 40 years of earnings and grow at 7% a year. Not bad! Certainly most people would feel great to have $1.3 million as their nest egg at age 65.

How much can you withdraw once you retire? 4% remains a safe answer, because you need to increase your withdrawals for inflation once you are in retirement. 4% of $1,365,488 is $54,619. How much of your salary will this replace? The answer is 41.7%. We can change the amount of your starting salary, but the answer will remain the same. With these factors (10% contributions, 2.5% wage growth, 7% rate of return, and 40 years), your portfolio would replace 41.7% of your final salary. That’s it! That could be a big cut in your lifestyle.

What percentage should you replace?

41.7% sounds like a really low number, but you don’t necessarily have to replace 100% of your pre-retirement income. To get a more accurate number of what you need, we would subtract the following savings:

  • You weren’t spending the 10% you saved each year to your 401(k)
  • 7.65% saved on FICA taxes versus wage income
  • Some percentage saved on income taxes, depending on your pre- and post-retirement income.
  • Your Social Security Benefit and/or Pension Income
  • Have you paid off your mortgage, or have other expenses that will be eliminated in retirement?

Many people will only need 75% to 80% of their final salary in retirement income to maintain the same standard of living. If their Social Security benefit covers another 20%, then they would only need a replacement rate of 55% to 60% from their 401(k).

Time Value of Money

The biggest factor in compounding is time. In our original example of 40 years of accumulation, the final portfolio amount was $1,365,488. However, what if you only save for 30 years? Maybe you didn’t start investing until 35. Perhaps you want to retire at age 55 and not 65? Either way, at the 30 year mark, the portfolio would have grown to $666,122. By saving for another 10 years, your accumulation will more than double to $1.365 million.

Here’s a chart that is perhaps a more useful answer to the question of what percentage you should save. It depends on how many years you will save and what percentage of your income you want to replace.

Income Replacement50%60%70%
in 40 Years12.0%14.4%16.8%
in 35 Years15.7%18.8%22.0%
in 30 Years20.9%25.1%29.2%
in 25 Years28.5%34.2%39.9%
in 20 Years40.3%48.4%56.4%

How do you read this? If you want to replace 50% of your income in 40 years from now, starting at zero dollars, you need to save 12% of your income. Actually, this is pretty close to the 10% rule of thumb. But no one says “If you are starting at age 25 and are planning to save for the next 40 years, 10% is a good rule of thumb”. What if you are starting later? Or, what if you want to have your portfolio replace more than 50% of your income.

As you reduce the accumulation period, you need a higher contribution rate. For example, at the 50% replacement level, your required contribution increases from 12% to 15.7% to 20.9% as you go from 40 to 35 to 30 Years. And if you are planning to retire in 20 years and have not started, you would need to save 40.3%.

Similarly, if you want your portfolio to replace more than 50% of your income, the percent to contribute increases as you stretch to 60% or 70%. These figures are quite daunting, and admittedly unrealistic. But one thing that may help slightly will be a company match. If you contribute 10% and your company matches 4% of your salary, you are actually at 14%. Don’t forget to include that amount!

What can you do?

We’ve made some conservative assumptions and perhaps things will go even better than we calculated. For example, if you achieve an 8% return instead of 7%, these contribution requirements would be lower. Or if the inflation rate is lower than 2.5%. Or if you can withdraw more than 4% in retirement. All of those “levers” would move the contribution rate lower. Of course, this cuts both ways. The required contribution rate could be higher (even worse), if your return is less than 7%, inflation higher than 2.5%, or safe withdrawal rate less than 4%.

If you want to consider these factors in more detail, please read the following articles:

If you’d like to play around with the spreadsheet, drop me an email (scott@goodlifewealth.com) and I’ll send it to you, no charge. Then you can enter your own income and other inputs and see how it might work for you. While our example is based on someone who is starting from zero, hopefully, you are not! You can also change the portfolio starting value to today’s figures on the spreadsheet.

The key is this: Begin with the End in Mind. The question of What percentage should you save depends on how long you will accumulate and what percent of income you want to replace in retirement. Saving 10% is not a goal – it’s an input rather than an outcome. Having $1.3 million in 40 years or $2.4 million in 35 years is a tangible goal. Then we can calculate how much to save and what rate of return is necessary to achieve that goal. That’s the start of a real plan.

You don’t have to try to figure this out on your own. I can help. Here’s my calendar. You are invited to schedule a free 30 minute call to discuss your situation in more detail. After that, you can determine if you’d like to work with me as your financial advisor. Sometimes, it isn’t the right fit or the right time, and that’s fine too. I am still happy to chat, answer your questions, and share whatever value or information I can. But don’t use a Rule of Thumb, get an answer that is right for your personal situation.

Can You Be Too Conservative?

As you approach retirement, you are probably thinking quite a bit about making your investment portfolio more conservative. We generally recommend that investors start dialing back their risk five years before retirement.

However, it is possible to be too conservative. Retirement is not an single date, but a long period of sustained withdrawals. We typically think in terms of a 30-year time horizon, which is not unrealistic for a 60 to 65-year old couple, given increasing longevity today.

The old rule of thumb was to subtract your age from 100 to determine your allocation to stocks. For example, a 65-year old would have 35% in stocks and 65% in bonds. Unfortunately, this old rule of thumb doesn’t work for today’s longer life expectancies.

Researchers analyzing the “4% rule” used for retirement income planning, typically find that optimal allocation for surviving a 30-year distribution period has been roughly 50 to 60 percent stocks. For most new retirees, we generally suggest dialing back only to 50/50 or 60/40 in recognition that the portfolio still needs to grow.

We still need growth in a retirement portfolio to help you preserve purchasing power as inflation erodes the value of your money. At 3% inflation, your cost of living will double every 24 years. So if you are retiring today and thinking that you just need $40,000 a year, you should be expecting that need to increase to $80,000 or more, to maintain your standard of living.

Another reason retirees should not be overly conservative: interest rates are very low today. Bonds had a much better return over the past 30 years than they will over the next 30 years. That’s not even a prediction, it’s just a fact. When we use projected returns rather than historical returns in our Monte Carlo simulations, it suggests that bond-heavy allocations are not as likely to succeed as they were for previous retirees. See: What Do Low Interest Rates Mean For Your Retirement?

The other side of today’s low interest rates is that some investors are reaching for yield and investing in much lower-quality junk bonds. While retirees often focus heavily on income producing investments, financial planners and academic researchers prefer a “total return” approach, looking at both income and capital gains.

We don’t want to take high risks with the bond portion of our portfolios, because we want bonds to provide stability in the years when the stock market is down. High Yield bonds have a high correlation to equities and can have significant drops at exactly the same time as equities.

We manage to a specific, target asset allocation and rebalance annually to stay at that level of risk. That gets our focus away from stock picking and looking at the primary source of risk: your overall asset allocation of stocks, bonds, and other investments. While no one can predict the future, a disciplined approach can help avoid mistakes that will compound your losses when market volatility does occur.

What Do Low Interest Rates Mean For Your Retirement?

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A 2013 study from Prudential considered whether a hypothetical 65-year old female retiree would have enough retirement income to last her lifetime. In their scenario, they calculated a 21% possibility of failure, given market volatility and longevity risk. When they added in a third factor of “an extended period of low interest rates”, the failure rate rose to 54%.

How to Make the 4% Rule Work for You

happily retired

Retirement planning today has largely shifted from guaranteed income from pensions to withdrawal strategies from 401(k) accounts and IRAs. Most financial planners recommend retirees start with an initial withdrawal rate of 4%. This approach was developed because historically, a 4% withdrawal rate, adjusted for inflation each year, would allow a retirement portfolio to last for 30 years under almost all circumstances.

The market was up in each of the past six years, which can give retirees a false sense of security about increasing their spending. In recent years, investors could take out 5%, 6%, or more from their portfolio and still end the year with more money than they started with. Markets go up and down, and if you withdraw all of your gains when the market is up, you can run into trouble when the market drops by 20 or 30 percent.

I find the challenge many retirees face with the 4% rule is forgetting to budget for unexpected expenses. If they have $1,000,000, a 4% withdrawal would be only $40,000 a year (before taxes). They can get by on this amount, but when their car needs replacing, they want us to send another $25,000. Suddenly, their annual withdrawal is up to $65,000. The next year, they need $10,000 for a new roof, and the next year, it’s something else. The issue is rarely reckless spending, but failing to set aside money for these unanticipated expenses.

The danger is that if a retiree takes too much, too soon, there won’t be enough remaining principal in their account to last for 30 years. Diminishing your account early in retirement means that future dividends and capital gains will be smaller in dollar terms, and cannot adequately replenish the annual withdrawals. Then the retiree may have to make drastic changes in their spending and lifestyle to avoid depleting their account. If there is a multi-year correction (like 2000-2002), combined with several years of large withdrawals, it is possible a retiree could see their portfolio drop to one-half their starting value in just five years.

I write this because the first challenge with the 4% rule is that many retirees don’t follow it and take out much more when the market is up. The good news, however, is that for the great majority of history, a 4% withdrawal rate was actually extremely conservative.

In a recent article by Michael Kitces, he examined the 4% rule, looking at 115 rolling 30-year periods, invested in a 60/40 portfolio. He found that in more than 90% of the periods, after 30 years of inflation-adjusted 4% withdrawals, a retiree would have finished with more money than they had at the beginning of retirement. In fact, the median wealth after 30 years, was 2.8 times the initial principal. The 4% rule was not an average withdrawal rate, but based on surviving a steep and prolonged downturn like The Great Depression.

Looking at all 115 30-year periods, Kitces found that retirees could have withdrawn a range of 4-10% of their initial principal, with a median of 6.5%. The 4% rule is the lowest withdrawal rate that worked, and since we don’t know future returns, the safest assumption. While that’s no guarantee that the 4% rule will work in the future, investors should feel very confident with this approach.

Now for some even better news: looking at all 115 periods, Kitces found that whenever the portfolio had grown to 50% above the starting value, withdrawals could be increased by 10%. This “ratchet” approach could be done every three years, and is on top of annual increases for inflation.

For example, let’s consider a retiree who started with a $1 million portfolio and experienced 3% inflation for 5 years. The annual withdrawal amount would have started at $40,000 (4%) and grown to $46,371 with inflation. If the portfolio were now to exceed $1.5 million, we could ratchet up their spending by an additional 10%, to $51,008 and that would become the new annual withdrawal amount.

Here’s a summary of how to make the 4% rule work for you:

1) Make sure you stick to a 4% withdrawal and don’t forget to set money aside for unexpected expenses.
2) Remember that the 4% rule is based on the worst case scenario of terrible market performance.
3) You can plan to increase your withdrawals each year for inflation.
4) If your portfolio grows to 50% above your initial starting value, you can ratchet up your annual withdrawal by an additional 10%.
5) Finally, recall that the 4% rule worked for a portfolio comprised of 60% stocks, 40% bonds. Don’t think that you can apply the 4% rule to a portfolio that is 80% invested in cash or CDs. It’s stocks that fuel the growth which enables the withdrawals to be increased.

How Much Can You Withdraw in Retirement?

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With corporate pensions declining in use, retirees are increasingly dependent on withdrawals from their 401(k)s, IRAs, and investment accounts. The challenge facing investors is how to plan these withdrawals and not run out of money even though we don’t know how long we will live or what returns we will receive in the market on our portfolio.

Pensions and Social Security provide a consistent source of income that you cannot outlive. When I run Monte Carlo simulations – computer generated outcomes testing thousands of possible scenarios – we find that the larger the percentage of monthly needs that are met from guaranteed sources, the lower chance the investor will run out of money due to poor market performance from their portfolio.

If you do have a pension, it is very important to consider all angles when deciding between a lump sum payout and participating in the pension for the rest of your life. It is not a given that you will be able to outperform the pension payments, especially if you are healthy and have a long life expectancy.

The most obvious way to avoid running out of money (called longevity risk by financial planners) would be to annuitize some portion of your portfolio through the purchase of an immediate annuity from an insurance company. While that would work, and is essentially the same as having a pension, very few people do this. You’d be giving up all control of your assets and reducing any inheritance for your beneficiaries. With today’s low interest rates, you’d probably be less than thrilled with the return. For example, a 65-year old male who places $100,000 in a single life immediate annuity today would receive $542 a month.

The problem with annuitization, besides giving up your principal and not leaving anything for your heirs, is that it doesn’t allow for any increase in expenditures to account for inflation. There are three approaches we might use to structure a withdrawal program for a retiree.

1) Assume a fixed inflation rate. In most retirement planning calculators, projected withdrawals are increased by inflation to maintain the same standard of living. After all, who doesn’t want to keep their standard of living? The result of this approach is that the initial withdrawal rate then must be pretty low. 20 years ago, the work of William Bengen established the “4% rule” which found that a withdrawal rate of 4% would fund a 30-year retirement under most market conditions.

On a $1 million portfolio, 4% is $40,000 a year. But that is just the first year. With 3% inflation, we’d plan on $41,200 in year two, and $42,436 in year three. After 24 years, withdrawals would double to $80,000. The 4% rule is not the same as putting your money in a 4% bond; it’s the inflation which requires starting with a low initial rate.

While we should plan for inflation in retirement, this method is perhaps too rigid in its assumptions. If a portfolio is struggling, we’re not going to continue to increase withdrawals by 3% and spend the portfolio to zero. We have the ability to respond and make adjustments as needed.

2) Take a flexible withdrawal strategy. We may be able to start with a slightly higher initial withdrawal rate if we have some flexibility under what circumstances we could increase future withdrawals. In my book, Your Last 5 Years: Making the Transition From Work to Retirement, I suggest using a 4% withdrawal rate if you retire in your 50’s, a 5% rate if you start in your 60’s, and 6% if retiring in your 70’s. I would not increase annual withdrawals for inflation unless your remaining principal has grown and your withdrawal rate does not exceed the original 4, 5, or 6%.

This doesn’t guarantee lifetime income under all circumstances, but it does give a higher starting rate, since we eliminate increases for inflation if the portfolio is shrinking. Under some circumstances, it may even be prudent to reduce withdrawals to below the initial withdrawal amount temporarily. That’s where having other sources of guaranteed income can help provide additional flexibility with your planning.

3) Use an actuarial method. This means basing your withdrawals on life expectancy. Required Minimum Distributions (RMDs) are a classic example of an actuarial strategy: you take your account value and divide by the number of years of life expectancy remaining. If your life expectancy is 25 years, we take 1/25, or 4%. The next year, the percentage will increase. By the time someone is in their 90’s, their life expectancy will be say three years, suggesting a 33% withdrawal rate, which may work, but obviously will not be sustainable. However, the more practical problem with using the RMD approach is that many people aren’t able to cut their spending by 20% if their portfolio is down by 20% that year. So even though it has a sound principle for increasing withdrawals, the withdrawal amounts still require flexibility based on market results.

But there are other ways to use the actuarial concept, and even my approach of different rates at different retirement ages is based on life expectancy. There’s no single method that will work in all circumstances, but my preference is to take a flexible strategy. But this does mean being willing to reduce spending, and forgo or even cut back inflation increases, if market conditions are weak.

We have a number of different tools available to evaluate these choices throughout retirement, but the other key factor in the equation is asset allocation. Bengen found that his 4% rule worked with equity allocations between 50% and 75%. Below 50% equities, the portfolio struggles to keep up with inflation and withdrawals become more likely to deplete the assets in the 30-year period. Above 75% equities, the portfolio volatility increases and rebalancing benefits decrease, increasing the number of periods when the 4% strategy would have failed.

When sorting through your options, you need candid and informed advice about what will work and under what circumstances it would not work. We hope for the best, but still have a plan for contingencies if the market doesn’t cooperate as we’d like. We will be able to consider all our options as the years go by and be proactive about making adjustments and corrections to stay on course. For any investor planning for a 30-year retirement, it’s not a matter of if the market will have a correction, but when. It’s better to have discussed how we will handle that situation in advance, rather than waiting until the heat of the moment.

Retirement Withdrawal Rates

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If you’re close to retirement, a key planning question is How much can I withdraw from my portfolio annually?  Or in financial planning terms, what is a safe withdrawal rate?  It’s a challenging question because we don’t know future rates of return.  But what we do know is that you can’t just project “average” or historical returns in a straight line and use that as your basis for withdrawals.

Unlike a portfolio in accumulation, a portfolio under distribution is greatly dependent on the order of returns.  We might have a 7% average return over 30 years, but in certain rare circumstances, a portfolio under distribution could be wiped out if there were negative returns in the first handful of years.  This is known as sequence of returns risk.

Today, we have several reasons to believe that future returns may be lower than historical returns.  This impacts the level of withdrawal that we can safely achieve in a retirement portfolio.  In my planning process, I use projected returns rather than historical returns, because I am concerned that historical returns may over-estimate the likelihood of success.

This issue is too complex to address in the space of a blog post, but I want to educate as many people as possible about the challenges of funding a retirement in a lower return environment.  I have written a whitepaper on this subject and strongly encourage anyone interested in their retirement to read more:

Five Reasons Your Retirement Withdrawals are Too High

If you’re not close to retirement, this is still a relevant issue because the amount you need to accumulate is determined on your future retirement withdrawal rate.  A simple way to calculate your finish line is by multiplying the reciprocal of your withdrawal rate times your annual need.

For example, a 4% withdrawal rate (1/25), gives us a multiplier of 25.  A 5% withdrawal rate equals a multiplier of 20.  If your annual need is $100,000, your portfolio target would be $2,500,000 under a 4% withdrawal program. Decreasing the withdrawal rate from 5% to 4% would increase your portfolio target from $2 million to $2.5 million.  And that’s why the safe withdrawal rate matters to everyone seeking financial independence.