I often hear rules of thumb that someone my age should save 10-12% of their income to fund their retirement. I don’t doubt that this is a good starting point, but rules of thumb like this simply can’t apply to everyone, because everyone wants different things out of their money and take different paths when saving for retirement. So if you can’t trust a rule of thumb like this, how do you know how much to save?
There is no way for me, or any financial advisor, to give a definitive answer to what your savings rate should be without knowing all the details of your financial situation. What I can do is make you aware of what you should be considering when you are deciding how much to save to point you in the right direction.
No two individuals are alike, and as an extension of that, no two individuals will want the exact same retirement. If one person’s retirement spending goals are roughly twice that of another person, his or her savings will need to be twice as high.
In order to determine how much they need to save, people need to arrive at some idea of their goals for retirement. The problem is, most people don’t even have an idea of where to start when thinking about retirement spending. I think a logical starting point is to simply try to replace the lifestyle they enjoyed before retirement, as this video from Dimensional Fund Advisors explains:
The rate at which savings grow has a big impact on the amount of saving required to fund a particular goal. To demonstrate this, let’s consult our financial calculator for a simple example. Suppose an investor wanted to accumulate a sum of $1,000,000 in 30 years to fund their retirement and can either put their money in investments that return around 9% each year or more conservative investments that return around 4%. How much would a person need to save at the beginning of each year to reach that $1,000,000 goal?
You can see the rate at which a person’s investment portfolio grows has a huge impact on the amount he or she needs to save each year to reach the same goal. And yes, this is an oversimplified example, as people don’t likely save in the form of one lump sum at the beginning of the year, and definitely, don’t receive the same exact return each year they are invested.
The purpose of this example is simply to show a sense of proportion, and the message is loud and clear: being conservative and investing in an asset class with a lower expected return requires you to save considerably more to reach the same retirement goal.
The impact of compounding can put the tremendous wind at your back as far as saving for retirement, but you need to give it time to take place. Using our previous example of a $1,000,000 goal with a 9% return, we see the impact of those extra years of compounding in our required savings rate.
Delay saving just 10 years and the required savings rate almost triples. Wait another decade until you are only 10 years away from retirement and the required savings rate can become a serious issue – your goals may be unattainable at that point.
What if you work in a field where you aren’t able to save as much up front but may be able to later as your income grows? Doctors come to mind – but people climbing corporate ladders will probably experience this as well. For people like this, you may need to start with a low savings rate and increase it as your income grows, as the video below from Dimensional Fund Advisors explains:
So how can you really know if you are saving the right amount at any given time? You have to create a financial plan that incorporates your goals and update it over time as your life changes. That will allow you to do the math and see how much you need to save to be confident you are saving enough.
A plan that is designed to fund your personal goals not only makes it much easier to find the motivation to save, it will also give you the peace of mind you are saving enough to fund the retirement of your dreams.
Disclosure: Examples are for educational purposes only. Individuals should always conduct their own due diligence or consult their own advisor before making any financial decisions.