Traditional advice is wrong: Here’s how much you actually need to save for retirement

I'm generally an even-keeled guy. I don't get worked up about much. I understand that different people have different perspectives, so I try to be respectful when others disagree with me. Having said that, there are indeed certain things that piss me off. Here are a couple that are centered around the idea of planning your retirement based on how much of your paycheck you should save.

Myth #1: You Need to Have 70% of Your Income

For instance, I get mad-dog lathered up at traditional advice about how much to save for retirement, such as this article at Business Insider (echoed here at The Wall Street Journal):

So how much are you supposed to be saving in order to finance 20 to 30 years post-work? The commonly accepted rule of thumb is that you'll want about 70% of your former annual income — at least — to continue living at or near the style to which you've been accustomed.

Let me be blunt: This rule of thumb is asinine.

This “rule” (which is used by most retirement calculators, both on the web and from financial planners) estimates how much money you'll need by using your income as a starting point. The 70% ratio is commonly used, but plenty of places use 80% or 90%. Regardless the percentage, estimating your retirement spending from your current income is ludicrous. It's like trying to guess how much fuel you'll use on a trip to grandmother's house based on the size of your vehicle's gas tank!

  • Say you make $50,000 a year but spend $60,000. In this case, your income understates your lifestyle by $10,000 a year. If you based your retirement needs on your income, you'd be screwed.
  • On the other hand, if you're a money boss who saves half what she earns, you'd only spend $25,000 of a $50,000 salary. Basing your retirement needs on your income would cause you to save much more than you need. You'd be working long after the point at which you could retire safely.

Predicting how much much to save for retirement based on income makes zero sense. (Zero!) It's one of those pervasive financial rules of thumb — such as “buy as much home as you can afford” — that does more harm than good. There's a real danger that if you heed this advice you won't have enough saved in retirement. If you're proactive like many Get Rich Slowly readers are, you run the risk of saving too much, meaning you'll miss out on using money to enjoy life when you're younger.

Instead of estimating how much to save for retirement based on your income, it makes far more sense to plan your retirement needs around your spending. Your spending reflects your lifestyle; your income doesn't.

So, how much do you need to save for retirement? How much will you spend? It depends.

For many people, expenses drop when they stop working. They drive less. The kids are out of the house. The mortgage is gone. And, ironically, they no longer have to save for retirement. Meanwhile, other expenses increase. (Most notably, health care costs tend to balloon as we age.)

That said, it is possible to get a general idea of how much you'll need in the future. According to the 2016 Retirement Confidence Survey: about 38% spend more in retirement than when they're working. 21% spend less, and 38% spend the same. Past iterations of this survey have shown that roughly two-thirds of Americans spend the same (or only slightly different amounts) during retirement as they did while working.

Translation: In general, your pre-retirement expenses are an excellent predictor of your post-retirement expenses. That's why I prefer this rule of thumb: When estimating how much you need to save for retirement, assume you'll spend about as much in the future as you do now.

Forget the “70% of your income” bullshit when planning for retirement. Use 100% of your current expenses instead.

Financial planner Michael Kitces — who has an awesome blog — sent me a note to explain why advisors use the “70% of your income” rule. The answer? “Because it works.”

Generally speaking, the 70% of income replacement ratio works because once you subtract taxes and work-related expenses (plus savings), it's close to 100% of expenses in most cases. I still think this is a crazy way to come at it — why not just use 100% of expenses? — and that it's completely off-base for folks with high saving rates. For more on this subject, check out Michael's article in defense of the 70% replacement ratio.

Myth #2: You Need to Save 10% of Your Income

GRS reader 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.

Figuring Out How Much to Save

Because you can't see the future, there's no way to know exactly how much you'll need to save for retirement. All you can do is make your best guess, taking these variables into account:

  • When will you retire?
  • How long will you live? (You can get an estimate at Living to 100.)
  • How much will you spend?
  • What will your health be like?
  • How much will you save and how aggressively will you invest?
  • What will the inflation rate be between now and the time you retire?

Because there's so much uncertainty, financial planners use Monte Carlo simulations, which analyze tons of historical data to estimate, based on your current savings and planned retirement date, how likely you are to run out of money in retirement. The results can help you plan how much money to save.

Monte Carlo simulations are great but complicated; you'll probably need to consult a financial planner if you want one run for you. But you can get started by making some rough estimates by hand — and with the help of web-based retirement calculators.

Tip: Delaying retirement can only help your financial situation. The longer you work, contribute to your retirement savings, and go without tapping Social Security and retirement accounts, the more money you'll have later.

A Better Way

If you're going to base your savings goals on how much you'll spend in retirement, you've got to have a way to gauge your future spending. Will your expenses increase or decrease? That depends in large part on your health and your plans. If you get sick or travel a lot in retirement, for example, your expenses may go up. In general, though, your expenses will likely stay about the same. According to the Employee Benefit Research Institute's Retirement Confidence Survey:

  • 49% of retirees spend less in retirement than before (26% spend much less)
  • 35% spend about the same as before retirement
  • 14% spend more in retirement (though 7% say their expenses are only “a little higher”)

Overall, 65% of Americans spend about the same or only slightly more or less in retirement. That means their pre-retirement expenses are a good predictor of their post-retirement expenses.

Expenses often drop in retirement because your kids are out of the house; your mortgage is gone—or nearly so (one of the surest steps toward retirement security is to pay off your mortgage); you have no commuting costs or other work-related expenses; and, ironically enough, you no longer have to save for retirement. Sure, you'll have other expenses — especially health care — but if you've been smart and planned ahead, you should be in good shape.

Make no mistake: You will need a sizable nest egg for retirement — especially if you have ambitions to travel or want to golf every day. In fact, you should save as much as you can. But don't be snookered by the constant refrain that you need 70% of your pre-retirement income. That's nonsense—base your savings goals on your projected expenses instead.

The moral here? Don't panic — you can save enough for retirement. In Retire Well on Less Than You Think, Fred Brock writes:

Most people can retire from wage slavery sooner than they think if they are willing to pay a relatively painless price for their freedom: a simpler, downsized life and, perhaps, a move to a less expensive part of the country — and it doesn't have to be remote or far away.

The key is to live within your means now, which lets you boost your cash flow so you can accumulate savings for later in life.

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.

Running the Numbers

Not every retirement calculator derives its numbers from pre-retirement income. During my research, I found several tools that let users project retirement needs based on other factors, including expenses. Some of these calculators are simple; others are more complex:

My favorite calculator, however, combines simplicity and complexity. FIRECalc 3.0 may seem overwhelming at first (there's a lot of text to read there), but it's actually fairly elegant. It asks for how much you have saved, how much you'll spend every year, and how many years you expect to live. Then, using historical data, it produces a graph to show you how likely your planning is to succeed:

FIRECalc shows you the results of every starting point, since 1871. You can get a sense of just how safe or risky your retirement plan is, based on how it would have withstood every market condition we have ever faced.

If you want to make the FIRECalc model more complex, you can. But it's possible to have fun with it — and to learn a lot — by just using the basic data fields on the main page.

“How much should I save for retirement?” is a complex question. There's no magic answer because nobody can see the future. All you can do is make your best guess while taking into account historical rates of inflation and investment returns, future health-care costs, and your estimated life expectancy.

Have you attempted to calculate your retirement number? What method did you use and why? If you're close to (or actually in) retirement, I'd love to hear your advice. How should those of us in the planning stages proceed?

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?

More about...Retirement

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