The other day, one of my good friends asked me how much he should be saving for retirement.
He had read online that he should be saving 10% of his paycheck, but he wasn’t really sure if that was the right amount.
FINANCIAL RULES OF THUMB
If you begin digging around the internet for ideas about personal finance, you’ll find a lot of principles that people say are good to follow. These “Financial Rules of Thumb” have been created over the years in order to give people quick reference points when considering each area of their financial lives.
The problem is, when you paint with broad brush strokes, you miss a lot of the nuances of each individual.
That is the reason for the creation of a series I’m going to call “Deconstructing Financial Rules Of Thumb.”
In this series, I plan to break down each of the generally accepted rules of thumb that have been created over the years and give you my opinion if they are something you should follow.
Let’s kick it off with my friend’s inquiry.
SAVING 10% OR YOUR INCOME FOR RETIREMENT
The basis of this one is pretty straightforward. You should be setting aside 10% of each paycheck into a qualified retirement account. This could be a 401(k), IRA, 403(b), etc.
The idea is that if you are saving this amount of money on a regular basis, you should be in a good place by the time retirement rolls around.
WHAT IT TAKES TO RETIRE
For us to know if the 10% rule is worth following, let’s look at what it actually takes to retire.
If we make a few assumptions, we can begin to gain some insight.
For starters, research shows that you should be able to live off of about 4% of your retirement account each year without running out of money. Some argue that it’s 3%, others 5%, but we’ll just use 4% as a starting point.
Another way to say this is that you will need an account value of about 25 times your expected annual expenses in retirement.
It is also recommended that you should aim to replace about 70-80% of your pre-retirement income once you are retired.
Lastly, the average American family makes just over $48,000 each year.
So, based off the average family income, the 4% rule (another topic we’ll dive into in the future) and your desired replacement income, how much will this family need in their retirement account when they retire?
Average Retirement Account Needed: $900,000!
CAN 10% GET YOU THERE?
The question becomes, if you need to reach $900,000 for your retirement nest egg (keep in mind, this is just for the average American family), will putting aside 10% of each paycheck get you there?
The quick answer is yes, it could. But there are a lot of variables at play.
For one, you need to begin at an early age. You also need to get a decent rate of return on your investment portfolio.
If the above family put 10% of their income into a retirement account beginning at age 25, received a 7% return, and retired at 65, they would have a nest egg of just over $950,000!
Winner, winner, chicken dinner!
But how many of you reading this right now began saving at age 25? What happens if you begin saving at 30? Or even 35?
If you begin saving at age 30, you’d only end up with an account value of about $664,000. And if you start at 35, you’d have $453,000.
No chicken dinner for you!
And if you still wanted to hit that $900K goal, but only started saving at 35, you’d need an average investment return of 10.7%, which is not very likely.
Being more realistic about investment returns, assuming something closer to 7-8%, if you begin saving at 35, you’d actually need to contribute around 16.5 – 19.8% of your income each year.
That’s up to as much as DOUBLE what this rule tells you to aim for. Yikes!
DOES IT MATTER IF YOU EARN MORE?
Your total dollar earnings are not the issue; it’s the percentage of savings where people get into trouble.
Even if you are making over $100,000 each year, you are still dealing with the same assumptions, albeit at higher dollar amounts.
So the answer is no, you’re still battling against the same math.
IN MY HUMBLE OPINION (IMHO)
The reality is that the 10% rule is a good place to start if you aren’t doing much saving, to begin with. After all, as of October 2017, the average US Personal Savings Rate was just 3.2%. So getting that up to 10% would be a step in the right direction.
But the 10% rule only works if you start saving at a very early age, and if you get a decent investment return along the way.
In my opinion, you’d be better off if you did some of your own calculations and figured out what your personal savings rate needs to be.
But the three things you can do that will always be helpful: Spend less, Save More, and Invest Early and Often!