.The new year is almost here and for a lot people a good New Year’s Resolution would be to start saving (more) for retirement. I frequently get asked “How much should I be saving for retirement?” The short answer: as much as you can. The long answer is there is no one correct answer since everyone’s situation is different. However, the following example of a hypothetical average household should hopefully prove helpful in gauging whether or not you’re on the right track for retirement.
The Average Joe household earns $51,939 per year (this is the median income for US households) and they are starting to save for retirement at age 30. Given that people are getting married later, have student loans to pay off, or may be starting off in a lower paying entry level job I think using age 30 as the point when someone starts to get serious about saving for retirement seems reasonable.
When the Average Joe’s go to retire they will be able to rely partially on Social Security for retirement income. If they retire at the full retirement age of 67 they’ll have $1,898 per month* or $22,776 per year from Social Security for retirement. So clearly, they’ll need to be saving up some money themselves for retirement. But how much should they be saving?
Well, we need to work backwards. How much money do the Average Joe’s want in retirement. Conventional wisdom says that when you retire your living expense will go down. You won’t have kids to take care of, hopefully your house is paid off, you won’t be commuting to work every day, etc. In reality, I’m not sure how true this line of thinking ends up being. As you age you may need help keeping up with maintenance on your house (such as hiring a lawn care service), medical expenses can add up quickly, or you might want to help out your kids with something like a down payment on their first house. When doing financial planning for my clients I usually like to stay on the safe side and assume that they’ll need about the same amount of money in retirement as they are making now. After all, changing your lifestyle can be very hard.
So, let’s assume the Average Joe’s need that same $55,939 in retirement. They’ll getting $22,776 from Social Security so they’ll need about $33,163 in income from their investment portfolio in retirement. There are various theories about what a “safe withdrawal” for investment portfolio is with estimates ranging from 3% up to 5%. Let’s split the difference and use 4%. For reference a safe withdrawal rate is the amount of money you can withdrawal each year without running the risk of running out of money. This means we’ll need a portfolio value of around $829,000.
What kind of the investment portfolio will the Average Joe’s have. In my experience the younger generation seems to be reasonably risk tolerant and many younger clients I’ve dealt with are comfortable with an aggressive growth type portfolio, let’s say 80% stocks and 20% bonds. The long term average annual return for stocks is somewhere around 9% to 11% depending on what data series and what time periods you look at. Again we’ll take the middle and use 10% for our calculations. The long term average return for bonds is a bit trickier to calculate with returns varying greatly by time period and by type of bond (Treasury, corporate, etc). Additionally bonds have benefited from a roughly 30 year period of falling interest rates (as rates fall the value of bonds increases). Given the low interest rate environment we are in now projecting historical bond returns into the future may not be wise. We decided to use 4% annual returns for our hypothetical bond portfolio. While it’s high by today’s standard remember that we are projecting average returns over the next 37 years. Finally, many investors will occur fees of some sort when it comes to investing. It could be the fees charged by a company 401(k), fees paid to an advisor, or fees paid to a mutual fund company. We will assume the Average Joe’s are paying 1% in investment fees.
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Adding everything up we get a 7.8% rate of return for the Average Joe’s investments. We will also need to do some fancy math to account for inflation. When doing these projections for my clients I like to use 2.85% as my annual inflation factor. That number represents the median rate of Social Security’s Cost-Of-Living-Adjustment (inflation adjustment) since the 1980s.
After crunching all the numbers we find that if the Average Joe’s put away $10,000 per year (this amount would include any contributions from their employers such as a 401(k) match) they’ll have an inflation adjusted portfolio worth around $782,000 in today’s dollars. This lets them withdrawal around $31,000 every year (in today’s dollars) in retirement to supplement their Social Security.
I’d wager that most Americans are behind on saving what they need to retire. As the Average Joe’s example shows, you really do need to be putting away a substantial amount to have a comfortable and financially worry free retirement. The New Year is a perfect time to start changing your savings habits.
*This is just a rough estimate which could change drastically depending on how the average Joe’s income was split between the couple.