Determining How Much to Save For Retirement

I love advising sessions with clients. Recently, I’ve had few with couples that have had the same issue: how to plan for retirement with a spouse. The couples that I spoke with were married, and therefore have the distinct opportunity of multiple types of investment vehicles to choose from when creating their plan.  On the other hand, dealing with two people makes it a bit harder when they are not on the same page with goals and/or have different appetites for risk. More on this later in the week.

The number one question I hear, however, hasn’t been about what type of account to have or what investments to choose, it’s “how much should we save?” With defined contribution plans calling on employees to take on the burden of funding their retirement, most have answered with a resounding “I’ll do it later.” According to the Employee Benefit Research Institute, half of workers are not confident they will be able to meet their needs in retirement. And I’m sure that some of the other half live in denial.

The quick answer to the question of how much to save is “as much as possible.” Max out your work place retirement plans and contribute to a couple of Roth IRAs if you qualify. Unfortunately, many people don’t have the option to do that and need to be a little more strategic in their planning.

Capturing the number that you will need to save to live comfortably in retirement proves pretty difficult.  You have to deal with many variables: your investment returns, inflation, the sustainability of social security, etc.  Online calculators don’t help much either. I can get vastly different results using the same assumptions.

Most advisors use one of two starting points for calculating how much you will need in retirement: 1) dying with zero and 2) living forever.

Dying with Zero

The first method involves a precise analysis using a Time Value of Money formula to predict how much money you can take from your portfolio over a certain time frame. Over this period of time (e.g., 30 years), you take an amount from the portfolio that uses all of the funds available to you. To me, the lack of margin of error in this method produces too much risk. If you live beyond that zero-money point, you will end up needing money at one of the most vulnerable times in your life.

Living Forever

A second approach involves estimating your anticipated living expenses (based on your current expenses) and then divide that number by your real (inflation adjusted) rate of return. William Bernstein, in The Four Pillars of Investing, calls this the “back of the envelope” method.  He thinks a reasonable rate would be 4%. So if you predict that you need $40,000 per year to live on, you have to amass $1,000,000 ($40,000/.04) by the beginning of your retirement.

This method still has its risks. Assuming too high a rate of real return will cause you to deplete your portfolio.  To hedge against this risk, Bernstein recommends withdrawing a consistent percentage of your portfolio, rather than a consistent dollar value.  For example, assume you have a $1 million dollar portfolio and you can safely withdraw 4% of it a year.  Instead of taking $40,000 every year, you determine 4% of the portfolio’s value every year. So while you may take $40,000 the first year, you may only take $36,000 the next, if your portfolio dropped by 10% (and was thus only worth $900,000). By taking the specific percentage and averaging the real inflation return, you don’t have to touch the principle investment. Therefore, your money will let you live forever.

Monte Carlo Analysis

A third option is doing a Monte Carlo Analysis. The analysis is a computer simulation that runs millions of “what if” scenarios and computes the percentage of times whatever strategy you propose will succeed.  It uses your initial nest egg amount, expected real rate of return, length of your retirement and the portfolio’s risk (standard deviation).  This simulation allows you to assume many different scenarios and try to determine which plan has the most chance of success. But one of the big drawbacks is it can’t anticipate huge market shifts like the Great Recession in its analysis. So you may still have to hedge your bets with this type of analysis by saving an extra 10-20%.

Know How Much You Spend

While all of these methods involve some risk, basing your retirement portfolio on what you need to live forever gives you the greatest chance of success. However, you will still need to know that yearly figure in order to predict that ultimate figure. This is where your budget and financial analysis come in. You can use your current income and expenses to determine your yearly nut – the minimum amount needed to meet your expenses. Then you make adjustments based on reasonable assumptions. Will your mortgage be paid off? Will you need to increase your health insurance costs? How much will you travel and what will that cost?  Many people also prefer using a percentage of your income (70 – 80% is common), as what you would need to replace to keep your same lifestyle.  

Again, there’s really no way that you can foresee or accurately predict the future. Regardless, you should try to exceed your goal of how much you need to save. To exceed that goal, you have to start early to take advantage of compounding interest and make sure to invest wisely