How much should you save for retirement? Carla dropped me a line because she’s puzzled where the standard “save 10% of your income for retirement” advice originated. She’s afraid that ten percent isn’t nearly enough. Carla writes:

The financial experts always say to save 10% for retirement (for example, in your review of The 1-2-3 Money Plan). Buy why 10%? It doesn’t make sense to me.

I’m 25. If I retire at the normal age of 65, that will give me about 40 years of full-time wage earning. Let’s say I plan to die at 85. That’s 20 years of retirement. I’m assuming that I’ll be fully funding my own retirement (not counting on any sort of pension or social security).

How on earth would saving 10% for 40 years cover your expenses for 20 years? I know that expenses should be a bit lower in retirement, and I know that the money will make some gains due to being invested, but really? How the heck could that ever add up?

The short answer to Carla’s question is that, in general, if you start saving early, and if you invest aggressively, 10% can often be enough. But there are a lot of things that could go wrong, too. The stock market could drop nearly 40% in the year you choose to retire (as it did in 2008). You might suffer a catastrophic illness. The country might experience hyperinflation.

Each of these things are unlikely, but they are possibilities. Because of this, many people save more than the 10% commonly recommended by experts.

Why 10%?
I think that the experts urge 10% because it’s a target people can understand, one that doesn’t seem too intimidating. It’s a convenient financial rule of thumb. My own opinion — and I’m sure the experts would agree — is that you should save as much as possible for retirement. Columnist Liz Weston has a great suggestion:

Save 10% for basics, 15% for comfort, 20% to escape. This rule of thumb works pretty well if you start to save for retirement by your early 30s. Saving at least 10% of your income ensures you won’t be eating pet food. Fifteen percent should get you a more comfortable living, while 20% gives you a shot at an early retirement (and yes, you get to count employer contributions as part of your percentage). Wait just a decade to start, though, and you’ll need 15% for basics and 20% for comfort; an early retirement may not be in the cards.

Tonight I asked my wife how much she’s setting aside for retirement. Her salary is nearly $60,000 a year. She’s setting aside $18,000 herself, and her employer is contributing $3,600. In other words, Kris is saving nearly a third of her gross income. But Kris hasn’t always saved this much. She didn’t save much at first, but has increased the amount she saves as her income has increased.

When you’re 25 like Carla, you’re probably near the low point of your earning potential. This is a huge reason that I’m advocate of banking your raises into savings accounts. In general, people earn more as they get older. Don’t use salary increases to fund lifestyle inflation, but instead use that money to save. It may take a few years, but eventually you can set aside 25% or more, just like my wife.

The power of compounding
Even if you set aside 25% of your income, though, how can that possibly be enough to cover your needs during retirement? If you’re worried about how much your investments can actually earn over time, take a look at two past articles:

Briefly, compounding can (and does) supply huge returns. These returns are magnified the longer your money generates the returns. That is, $1000 invested at 10% for twenty years doesn’t just earn double the amount you would earn if the money were invested for ten years.

Playing with this compound interest calculator, the first scenario generates $2593.74 while the second produces $6727.50. (And leaving the money there for 40 years would produce $45,259.26!) There’s a reason financial advisers urge people to begin investing early. Returns are magnified with time.

Are 10% returns realistic? Perhaps. Although even the best CD rates aren’t returning rates that high now, as the article above demonstrates, the average long-term return on U.S. stocks is roughly 10%. This is what stocks have returned in the past.

Making the most of your money
Having said that, there are some important things to remember.

First, as mutual fund advertisements are eager to tell you, “Past returns are no guarantee of future results”. Just because the stock market has returned about 10% in the past doesn’t mean it will do so in the future. (Warren Buffett has said that he expects stocks to offer much more modest returns over the next century.)

Second, average is not normal. Yes, it’s true that the U.S. stock market has an average annual return of about 10%. But that doesn’t mean that it returns 10% every year. Some years — like 2008 — the market drops by 39%. Some years — like 2009 — the market grows by 18%.

Here are a few keys to obtaining steady returns from your investments.

  • Have a plan. Develop an investment plan built around your age, your goals, and your circumstances. Ask yourself how much risk you’re willing to take. Some people are willing to take on greater risk in order to have a chance at higher rewards. Whatever the case, take the time to draft a plan that makes sense. Refer to this plan whenever things become confusing. Reminding yourself of your plan can keep you from overreacting — in good times and in bad.
  • Don’t be an emotional investor. I’ve heard from a lot of people who invested near the top of the stock market in 2007 — and then sold last winter. This is buying high and selling low. It’s a sure way to lose your shirt. When the market tanks, don’t panic. When it’s riding high, don’t get caught up in the euphoria. Have a plan. Keep making your contributions. Thing long term and ignore the short-term noise — no matter how loud the noise might be.
  • Don’t raid your retirement. It can be very tempting to raid your retirement account to buy a new home or to take a trip to Europe — or even to put food on the table when you’re out of work. This is usually a bad idea. When you tap into retirement early, you’re subject to taxes and penalties — and you’re robbing from your future self. You’re robbing not just the money you take, but also the returns it might have generated over the years.
  • Make regular contributions. Get in the habit of saving for retirement by investing regularly. Make it automatic, if you can. The best way to do this is to enroll in an employer-sponsored program and have the money taken from your paycheck. This way the process is invisible to you. Regular contributions to a retirement plan allow you to take advantage of dollar-cost averaging.
  • Take advantage of free money. If you have access to an employer-sponsored retirement plan, use it. When your employer matches your retirement contributions, it’s like getting free money. There are few better deals in the financial world. (Are there any better deals?)

Each of these actions can help you obtain better long-term results from your retirement savings. But the real key is to start now. The sooner you begin, the more time you have to accomplish your goals.

How much should you save?
Retirement planning is a complicated subject, and I’ve only scratched the surface here. There are a lot of variables I haven’t covered (taxes, inflation, etc.). Carla is way ahead of the game by asking these questions now.

So, how much of your income do you save for retirement? Do you save 10% like Carla? Do you save 25% like my wife? How have you arrived at this amount? Do you plan to save more in the future? I’m especially interested to hear from those who are in or near retirement. Do you wish you had saved more when you were younger? What would you do differently? What advice can you offer folks like Carla who are just starting out?