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The Most Important Financial Planning Question You Need to Answer

How much should you save toward retirement? Conventional wisdom tells us we should invest as much as possible for retirement in a well-diversified portfolio, and time will take care of the rest. Although this approach is simple, it does not answer a basic question: how much do I need to save, based on my unique situation? We can help you answer this question.

1) How old are you? / When do you intend to retire?

Generally, younger people who start saving early are in better positions than those who wait. Some studies have shown that the recommended savings rate for individuals who start to save at age 25 doubles if they wait until age 45, and triples if they wait until age 55 to start saving. While most people plan to retire in their 60s, some wish to work later in life, and others wish to retire earlier.

2) What percent of your pre-retirement income will you need in retirement?

In the financial planning world, this metric is known as your income replacement ratio. For most people, expenses decrease in retirement. In fact, studies show that health care related expenses are the only category of expense that will increase in retirement. In view of this, many financial planners recommend an income replacement ratio of 80%. Social security will cover some of this, but personal savings, other sources of income, and retirement accounts will need to cover the rest.

3) How much do you expect to earn from your investments?

Although there is never a guarantee in the financial markets, we do know that over time, stocks tend to outperform bonds and bonds tend to outperform cash. For long-term investors who invest primarily in stocks or stock mutual funds, planning for a 7% annual investment return is generally reasonable. Just remember, financial markets can be volatile over shot-term periods, so sticking to a long-term plan, even when you might be fearful is critical. However, always consult with professionals if you need specific advice.

4) How much have you already saved towards retirement?

If you have already started to save, you are in a far better position than those who have not.

5) How long do you need your retirement savings to last?

Actual life expectancy is unknown and planning for it is challenging. When attempting to plan for this, some people look at their family histories, lifestyle choices, current health situation, expected future health care advances, etc. All of these are sensible and appropriate. Generally, planning for a retirement of 20 years to 30 years is reasonable for most people.

Once we have answered the above questions, we can determine an appropriate savings rate. The below tables provide targeted retirement savings rates, based on a study published in the Journal of Financial Planning in April 2007.

Target Savings Rate by Age and Income

Income

25

30

35

40

45

50

55

60

20,000

5.8%

7.0%

8.6%

10.2%

12.4%

15.0%

18.6%

23.8%

40,000

8.2%

10.0%

12.2%

14.8%

18.0%

22.0%

27.2%

34.4%

60,000

10.0%

11.8%

14.6%

17.6%

21.4%

26.2%

32.6%

41.2%

80,000

11.2%

13.6%

16.4%

19.8%

24.0%

29.8%

36.6%

46.8%

100,000

   

17.6%

21.4%

26.2%

32.2%

40.2%

51.4%

120,000

       

28.2%

35.0%

43.6%

55.4%

 

Subtract from Target Savings Rate for each $10,000 Already Saved

20,000

1.60%

1.65%

1.75%

1.67%

1.76%

1.87%

2.11%

2.39%

40,000

0.78%

0.79%

0.86%

0.86%

0.90%

0.97%

1.04%

1.23%

60,000

0.55%

0.54%

0.55%

0.57%

0.59%

0.64%

0.71%

0.81%

80,000

0.40%

0.42%

0.43%

0.42%

0.45%

0.48%

0.53%

0.61%

100,000

   

0.34%

0.35%

0.37%

0.39%

0.43%

0.50%

120,000

       

0.31%

0.33%

0.36%

0.41%

For example, suppose a 40-year old earns $60,000 in annual income. Based on the first table, this individual has a suggested savings rate of 17.6%. Put another way, the 40-year old would need to save $10,560 per year towards retirement.

Now suppose the same 40-year old has already saved $50,000 towards retirement. From the second table, we reduce the savings rate by 0.57% for each $10,000 already saved. In this situation, the recommended savings rate is 14.75% = 17.6% - (5 x 0.57%). Here, the 40-year old would need to save $8,850 per year towards retirement. Obviously, starting to save for retirement early can be tremendously helpful.

The above tables are not without their limitations. They were built around single individuals with an 80% income replacement ratio, retiring at age 65 with full social security benefits. Although this may not be entirely consistent with your situation, the tables can serve as a useful starting point and guide. If you would like to learn more or review your specific situation, our IRA Consultants are happy to help.