By K. Bridget Schneider, CFP®, CRPC®
Are you confident about how much you will need to save for your retirement? There are several rule-of-thumb benchmarks that you can use to gauge your saving for retirement, but how well does a rule-of-thumb fit your situation? Let’s examine four commonly used guides so you can be the judge.
The Million Dollar Rule
For years, many people felt reaching one million dollars in net worth was enough to live comfortably in retirement. Net worth is total assets minus total liabilities. You simply add up all your savings, investments, and the value of each property such as a house, cars, and other valuables, then subtract any debts you owe.
Unfortunately, if a large part of your net worth is in your home, it will be difficult to use that portion for retirement income. Even if you have a million dollars in liquid assets, increases in the cost of living and the actual rate of return on your investments can reduce the number of years it will last. Consider that your retirement may last for twenty to thirty years. Now think about the price of a loaf of bread thirty years ago compared to its cost today.
Income Replacement Ratio
This is the amount of income you feel you will need to maintain your standard of living in retirement divided by your pre-retirement income. This typically estimates a replacement ratio of 70% to 80%. Some feel that you won’t need to replace all your pre-retirement income, since expenses may be lower in retirement. This could be due to the elimination of some work-related items and lower income taxes.
For example, a person with $100,000 in pre-retirement income might use $75,000 as their estimated annual retirement income need. Next, subtract any other sources of annual income such as pensions, Social Security, or part-time work. The result is the amount of annual income your retirement savings needs to cover. Then multiply that annual figure by the number of years you think you will live.
I have two concerns with this calculation. First, spending habits differ from household to household. Sometimes retirees justify extra expenditures in the early retirement years for travel or other luxuries so that they can be enjoyed while they’re still able. Also, you may spend more than you expected in retirement since you have more time to pursue your interests. Second, inflation may cause cost-of-living increases so that you need more each year than you had calculated. All of these will affect how long your retirement savings will last.
Age-Based Salary Multipliers
This simple rule-of-thumb was created by Fidelity Investments. It uses age-based milestones and assumes you are saving 15% of your annual income beginning at age 25, investing more than 50% of it in stocks over your lifetime, retiring at age 67, and continuing your pre-retirement lifestyle in your retirement years. They suggest your retirement savings goal should be
- 1x your salary by age 30
- 3x your salary by age 40
- 6x your salary by age 50
- 8x your salary by age 60
- 10x your salary by age 67
For example, a 50-year-old earning $100,000 per year would target $600,000 in retirement savings to be on track to retire comfortably at age 67.
But what if you want to retire at age 60? Or what if you are eligible for a substantial pension in retirement? These facts will cause this rule-of-thumb to be less useful to you in checking your retirement preparedness.
The Four Percent Rule
This rule-of-thumb suggests you may withdraw 4% of your retirement savings every year to supplement retirement income from pension(s), Social Security, or other sources. The goal is to provide a steady income stream while maintaining a portfolio that will continue to provide income through retirement, so you don’t run out of money.
Most experts consider the 4% withdrawal rate to be safe depending upon the asset allocation of investments in your retirement savings. It was created using historical data on stock and bond returns over a 50-year period. For example, if you have one million dollars in your retirement savings, you could withdraw $40,000 a year.
This rule could provide increases in income to keep up with inflation and its effects on your cost of living. However, the 4% rule does not work unless you stick to it year in and year out. If you violate the rule one year to splurge on a major purchase, it can have severe consequences down the road. This is because it reduces the principal, which directly impacts the compounding that you are counting on for sustainability.
Gauge Your Saving for Retirement Assistance
While all these rules-of-thumb are useful tools to gauge your saving for retirement progress, none of them fit all situations or guarantee your success. If you have doubts about where you are in saving for retirement, I suggest enlisting the help of a CFP® Professional for a closer look at your unique situation.
As your friendly financial guide and ally, we can help you structure a plan to get started on the right path together. For more information on financial and retirement planning, visit our website today, call us at 217-605-8130, or click here to schedule a free, no obligation consultation.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax or legal advice.