What percent of my income should I save for retirement?

I recently got an email from our HR department at work saying that I should be saving for retirement (Thanks guys!).  The email included a nice little graphic which seemed to suggest that I should save 6% of my salary.  Based on the assumptions (annual return of 7%), if I am 30, earn 40,000 a year and put 6% away for 30 years I will have $234,860 (in today’s dollars).  If I retire at 60, and expect to live until 80, that means I’ll have about $17,400 to live on per year in retirement.  (Its more than $11,700 (234,000/20 years) because I earn interest on the money that I haven’t taken out yet).  Either way, 17,400 isn’t much – especially considering the fact that I plan on living past 80 and $17,400 is less than half of the salary I would be used to.  Clearly 6% is not enough.

How much is enough? If 6% is not enough, then what is?  This is such an important question because it should be the foundation of your monthly budget.  If you are trying to do things right, you set aside money for your retirement first, and then see how much you have left to spend on everything else.  Again, its that old expression, “pay yourself first.”  So, what is a good percentage of gross income that you should be saving?  The typical rule of thumb is that you should save 10% of your salary for retirement.  But as the linked article suggests, even 10% may not be enough.  You may be 42 years old with no money saved for retirement (you’ll need to save much more than 10% of your income) or 25 and trying to retire early.  So while 10% of your income seemed like a good place to start as a minimum, it was clear to me that I needed to do some extra research to come up with a percentage that was more than just a rule of thumb.

I started playing with the zillions of online retirement calculators out there (just google “retirement calculator”) and quickly realized that “annual savings as a percentage of income” was just one of many variables in their complex retirement equations.  Fortunately,  Vanguard’s retirement calculator was simple enough to allow me to easily isolate the “savings as percentage of income” variable.   Even with its simplicity, however, the Vanguard calculator still required me to make some assumptions about retirement.  I’ve included a screenshot of what they look like in the Vanguard calculator as well as an explanation of my assumptions below.  In general, the assumptions are set for the average 25 year old who is thinking about retirement for the first time.

  1. How old are you and when will you retire?  25, 65.  Unless you have visions of jet-setting at age 50, the standard answer is age 65.  I can see the argument to use age 70 since we will probably be living longer than the current generation and social security benefits might not start until 70 when we are in the year 2050. It is much easier, however, to plan to retire at 65 and later decide to work until 70 than it is the other way around.
  2. What is your current annual income? $50,000.    This number is only relevant because it is used to determine the actual dollar value of how much money you will spend per year in retirement.  According to Vanguard (and most other retirement calculators), the typical retiree spends 85% of his pre-retirement  annual gross income in a year.  The blue bar in the chart at the right displays the result of this calculation; ($50,000 * 85% / 12 months = $3,542 a month).
  3. How much do you save annually for retirement?  To be determined.  This is the variable that we are trying to figure out, with the focus on the percentage of annual income and not the actual dollar value.  Note that it should include your personal contributions to an IRA, as well as any work contributions (including employer matching) in 401(k)s and 403(b)s.
  4. How much have you already saved for retirement?  $0.00.  I am assuming that you are just starting out.  If you have some money already saved, I encourage you to input all your information into calculator to get a personalized look at your retirement plan.
  5. What’s your market risk approach (In other words what will the average annual return of your investments be)?  Somewhere between 4% and 8%.  Part of this will be determined by the investments you select.  If you have a more conservative portfolio with a heavy percentage of bonds you can generally expect a lesser return than a more aggressive portfolio consisting mostly of stocks.  But even if I assumed that everyone had the same retirement portfolio, I still can’t predict how it would perform over the next 30 years. In the past your investments may have made 7% a year, but what if over the next 30 years it only averages 6%?  Click here for a great graphic from the New York Times that depicts the variability in 20 year returns.
  6. Will you receive any money from social security or pension? Maybe… If you are lucky enough to be in a profession that still distributes pensions, then great, you can include that income here.  Most of the private industry jobs out there now, however, do not distribute pensions, so the standard answer is $0 from pensions.  Whether or not you will receive any money from social security, however, is the bigger question.  There are countless articles out there detailing the unsustainable state that the social security system is in.  This article was the best I’ve found explaining the situation, and even offers some actionable advice.  If no policy changes are made, social security benefits will eventually have to be cut by one third.
  7. How long will you live in retirement?  Doesn’t matter.  This is not explicitly asked on the Vanguard calculator, but it is used in the behind the scene calculations.  Some retirement calculators use an equation that ensures you spend all your retirement money by age 85 (the standard guess for how long you will live).  Vanguard however uses the 4% rule.  The idea is that once you are in retirement, your nest egg will be put into more conservative investments where 4% is a typical return.  If you only take out 4% of your nest egg every year to live on, then that 4% will be replenished by investment gains and your nest egg will never lose value.  By using the 4% rule, you reduce the risk that you will run out of money if you live longer than you expect.  The “downside” is that when you die you might not have used all of your money up.  By using the Vanguard calculator and its 4% rule, the amount of money they recommend you save for retirement may be higher than the other calculators, but I think it is a much smarter approach than trying to guess how long you’ll live.

How can I plan for retirement if I can’t predict my rate of return or if Social Security will exist?  You’ll notice that I have answers for all of Vanguard’s questions except for two: “Will I receive money from Social Security?” and “What will my average annual rate of return for my investments be?”  Without knowing the answers to these two questions it is impossible to come up with an educated guess on what percent of my gross income I should be saving for retirement.  Because I don’t have a crystal ball, I settled for the next best thing – a spreadsheet that lets me test different scenarios.

In the interest of full disclosure, you should know that this spreadsheet is simply a recording of the values taken from Vanguard’s retirement calculator.  So for example, to get the 10% value at the bottom right of the chart, I set the “market risk approach” slider to 9.5% , set my social security benefit to $833 a month (20% of $50,000 / 12 months), and then adjusted the “how much do you save annually” slider until the green bar was equal to the blue bar.

So what does it all mean? First of all, saving 10% of you gross income is not nearly enough.  The only way that would work is if you received a significant amount of social security benefits, and your retirement portfolio earned a ridiculous 9.5% return per year.  Personally, counting on a 6% – 7% return seems much safer to me.  If you read my post on target date funds, you know that the investment style starts out very aggressive (90% in stocks) and gets more conservative as you get closer to retirement (65% stocks with 10 years to go).   So even though I have an “aggressive” portfolio, I’m still not counting on getting any returns out of the ordinary.

What percent of my income should I save for retirement? So here we are, finally back to the original question.  The answer is about 20%. If you are expecting a 7% return on your investments (a reasonable/slightly conservative guess) then you’ll need to save between 17% and 22% of your gross income every year – depending on how much social security you expect.  If you are making $50,000 a year and retired today, you could expect to receive social security benefits that would cover 37% of your current income.  As noted above, however, it is highly unlikely that social security will be around in the same form when you retire.  If it is still around, a safe bet is that you can expect to get 1/3 of the benefits you would receive today.  In other words, you could expect social security to cover 12% of your current income.  If thats the case, you would need to be saving about 20% of your annual income per year.

I guess what I’m saying is that 20% should be the new rule of thumb.  Now, I’ll be amazed if any of my friends saves anywhere near this amount.  I mean, lets face it, 20% is a lot of money.    But that is the reality these days; because unlike our parents, we can’t rely on pensions or social security or even a US economy that is growing like crazy.  Obviously, it would be great if the market continues to grow and all of the asumptions prove too conservative.  And if thats the case then that means you can travel to your hearts desire or even leave a little extra to your kids.  I don’t see a downside there.  But if you only save 10%?  Anything other than great returns and lots of social security means you wont have enough to retire.  Its a tough pill to swallow – having to save 20% of your income – but it is the only way that the numbers work.  Its honestly kind of hard to believe that the advice I was given was to save 6%…

The example is only for someone making $50,000 a year.  I make more (or less) than that, what percent should I be saving?  For our purposes, the annual income is irrelevant because everything can be depicted in percent of income.  The actual amount of your current income does not matter when figuring out what percentage of income to save.  If you make $100,000 dollars a year, you will have a higher standard of living in retirement ($85,000 a year) but by saving 20% of $100,000 you’ll be saving enough money to account for the higher standard of living.  The only thing that changes when you make more money, is that your expected benefit from Social Security decreases (as a percentage of income).  Here is a chart explaining this (All data is from SSA.gov).

If you make $50,000 a year and retired today, social security would pay you about 37% of your current income.  If you make $100,000 and retired today, social security would only pay you about 26% of your current income.  The take away here is this:  if you assume that you will only get 10% of your income in social security benefits, then at $50,000 a year that represents a much larger cut from current benefits than at $100,000 a year.  If you don’t assume any social security benefits, then your current income has absolutely no affect on the  “Percent of Annual Income Needed to be Saved” chart.