Finding the Right Savings Rate for Your Retirement Needs
August 25, 2009
Making Your Savings Last: Key Factors In Retirement Planning
Suppose you've been diligently saving for retirement. You have built up your savings account, and have diversified into longer-term investments. You continue to make regular contributions to this nest egg. The question is, how do you know when your savings rate is high enough?
This is a difficult question, because it requires looking many years into the future. It's not just that your retirement date may be several years off, because the key isn't how much money you have when you retire. The real key is making that money last through retirement.
To give you a feel for whether your current savings rate will be adequate, you should think about some of the key assumptions that go into retirement planning, and whether or not you have accounted for those assumptions realistically.
What You Should Know About Key Assumptions
Planning for retirement typically means running a calculation which projects your savings and investment earnings until your retirement date, and then looks at how much you can afford to spend in retirement. There are several computer models that will do this for you, but they all rest on some central assumptions, such as:
- Return assumption. Financial planners generally use long-term financial market history to make assumptions about what kind of average returns you will earn over time. That's reasonable, but as recent history has proven, sometimes markets can under perform their historic returns for periods of a decade or more. Also, be advised that most historical return assumptions were probably drawn from periods when interest rates were higher than they are now, which gives today's savers a bit of a handicap.
- Inflation assumption. Inflation may not have been much of a factor lately, but historically it has run at an average of 3.76% per year. Over time, that can significantly erode the purchasing power of your savings. Suppose you plan on retiring in 25 years, and at your current savings rate you would have a million dollars at that time. That may sound pretty good, but be advised that by then, that million dollars would only be worth the equivalent of $397,126 today.
- Life expectancy. People save toward a retirement date as if it were the end of the story, but with any luck it will only be the beginning. You should live several years into retirement. A woman born today can expect to live to be nearly 80, but that doesn't mean that she should plan on only ten years of retirement if she retires at 70. That average life expectancy includes people who die young; if she lives to be 70, that woman can actually expect to live nearly 16 more years. And remember, that's just an average, so roughly half the population would live longer than that. This means your retirement savings may have to last longer than you think.
Implications for Your Savings Rate
As you can see, the fundamental flaw in any retirement planning model is that it is based on a series of assumptions that seem straightforward, but which are actually highly variable. The one factor you have direct control over is your savings rate. Therefore, given the uncertainty of the outcome, the most positive action you can take to affect that outcome is to increase your savings rate at every opportunity.
Source:
Social security online: http://www.ssa.gov/OACT/STATS/table4c6.html
Bureau of Labor Statistics: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet
