Last week, I discussed the challenges people have envisioning what their retirement lifestyle will look like due to changes in one’s personality, values, and preferences. If you’re unable to imagine your exact retirement lifestyle, is planning for it futile?
Two research papers answer that question with an emphatic “no.” Planning and saving for retirement are vitally important. The income base that sufficient investments, social security, and (for some) pensions provide options for a variety of retirement lifestyles. Those lifestyles wouldn’t be possible on Social Security income alone. As my parents use to say, “money provides you with options."
The two papers “How much should people save?” by Munnell, Webb, and Hou of Boston College and “How much should I save for retirement?” by De Sanis and Lee of Dimensional Advisors, focus on providing enough income in retirement to replace a majority of one’s pre-retirement income. Why not 100% of pre-retirement income?Because, in retirement, one does not pay FICA taxes, is not saving for retirement, has (hopefully) paid off all debts and has no work-related expenses.
But what about travel, hobbies, and health care costs? De Sanis and Lee’s paper takes this into account when they determine the required income replacement rate.
The key questions answered by the research are: “How much of my retirement income should come from my investments?” and “What percentage of my income should I be saving for retirement?”. Keeping in mind that each person’s situation is unique, there are some reasonable guidelines from the research that answer these questions.
Both papers suggest that one have sufficient financial assets to replace 35% to 40% of pre-retirement income. I would recommend a more conservative 40% replacement rate which would provide you with more options at retirement. What should your financial assets be to meet the 40% goal? Assuming an annual withdrawal rate of 4% per year of your financial base for retirement income, you should accumulate 10 times your final pre-retirement gross income. To see if you’re roughly on track, look at Table 7 in De Sanis and Lee’s paper. For a 45-year old couple who have a joint gross income of $100,000, they should have accumulated $375,000 to be on track to reach the goal (financial assets which are 10 times their gross income) by age 65.
Both papers offer similar guidelines to the second question, “What percentage of my income should I be saving for retirement?” They suggest a savings rate of 15% of your gross income starting by age 30 and continuing that savings rate throughout your working life. This is only an approximate suggestion, and it is important to check your progress at various times throughout your working life to see if you are on track.
Planning and saving for retirement is a complex problem that spans the decades of a working life. Certainly, everybody should seek the counsel of a qualified financial advisor to see if they are on track to have sufficient income during retirement. In lieu of specific advice, the two rules of thumb provide a good starting point for most people: Accumulate financial assets that are at least 10 times your gross household income. Save at least 15% of your gross income.