Benjamin Franklin wrote, “A penny saved is a penny earned”; but when it comes to saving for retirement, it might be best to remember that a penny not saved, is a penny lost.

Simple Math

Personal financial advisors have come up with several methods with which you can calculate your “retirement number”–the amount of savings you will need in order to maintain your standard of living after retirement, depending on your annual salary, and expected age of retirement. The easiest method requires you to multiply the salary that you earn in your final year of employment by a factor that varies from advisor to advisor.

Some advisors recommend that clients multiply their final year’s salary by 12, to determine whether or not they have saved enough to retire at 65 years old; while others argue that a factor of 8 is sufficient to provide for a comfortable retirement. In a recent survey of 2.2 million employees at 78 large U.S. companies, human resource consulting firm Aon Hewitt based its estimation of the ideal retirement savings goal by multiplying the final year’s salary by a factor of 11. Though simple, this method depends on certain basic assumptions that must be understood.

Behind the Retirement Numbers

First, advisors assume that the retirement savings accrued by their clients are held in one or more conventional retirement savings accounts–whether an employer-sponsored 401(k), or Simplified Employee Pension Plan; or a self-directed individual retirement account (IRA). Established by the U.S. Congress in the 1970s and 80s, these account types were designed to incentivize saving for retirement by providing workers with tax benefits and investment options that allow their money to grow at a faster rate than if it were held in a traditional savings account. Workers contributing to an employer-sponsored 401(k) not only benefit from tax-deferred growth but may also receive matching contributions from their employers.

Second, this simplified method of determining ideal retirement savings relies upon average life expectancy–which is currently estimated at 76 years old for men, and 81 years old for women in the United States. Obviously, a healthy person with a family history of longer-than-expected lifespans might want to save for a longer period of retirement or plan to fully retire at a later date.

Continuation of Social Security Benefits

Furthermore, this method anticipates the continuation of Social Security benefits throughout retirement. Nearly all workers employed in the United States are legally required to have money withheld from their paychecks in the form of a Federal Income Contributions Act (FICA) tax or a Self Employed Contributions Act (SECA) tax, which is entrusted to the series of government-run financial entities comprising the Social Security Trust Funds. Monthly retirement income from Social Security depends upon the amount of money contributed by a worker over the course of his or her lifetime, and the age at which he or she begins collecting benefits.

However, financial advisors strongly caution that Social Security benefits alone cannot adequately support a person throughout retirement. Moreover, because of the rapid annual rise in individuals claiming benefits, the Social Security Board of Trustees announced in 2012 that the surplus currently bridging the gap between the program’s revenues and expenses will be depleted by 2021; and that the fund will be exhausted by 2033–three years earlier than expected. Consequently, personal financial advisors recommend that clients whose retirement is more than 10 years away should exclude Social Security benefits for their estimates of post-retirement income. According to Aon Hewitt’s report, this may mean multiplying your final year’s salary by 16.

The 80% Rule

Lastly, and most importantly, determining your retirement number simply by multiplying your annual income by 8, 11, or 12 relies upon the timeworn 80% income replacement ratio that financial advisors have been quoting since the early-1980s. According to the “80% Rule”, people saving for their retirement should plan to replace their salaries with revenues equivalent to 80% of their pre-retirement income in their final year of employment, in order to maintain their standard of living; an amount that may, or may not be adequate. The 80% Rule assumes a current personal savings rate (the percentage of income saved each year) of about 20%.

For people currently saving 20% or more of their income, the reduction of their annual revenue probably won’t necessitate a lifestyle change. People who struggle to save money each year, however, may find that an income replacement ratio of 80% requires a significant reduction in their standard of living. Moreover, people who wish to travel, or pursue other potentially costly hobbies after retirement, will need more money to do so. Additionally, since many Americans delay retirement until paying off their largest expenses (e.g. mortgages, loans, etc.), the 80% rule assumes an overall reduction of living expenses during retirement; but neglects to account for increased healthcare expenses–which, for an average American, can exceed $220,000 over the course of retirement.

Your Personal Savings Rate

To adequately account for these and other desired or likely changes in your post-retirement lifestyle, therefore, you should calculate your retirement number using your anticipated annual post-retirement expenses, instead of your pre-retirement income. Begin by determining your personal savings rate–the percentage of your income that you currently save, each year. Add up the amount of money you save, each year. Be sure to include non-retirement savings, as well as total contributions to your 401(k) or IRA; but ignore capital gains or interest income, if applicable. Divide that sum by your annual salary after taxes, making certain that you include 401(k) contributions made by you and your employer.

For example, let’s say you took home $60,000 last year, after taxes. You contributed $6000 to your 401(k), and your employer made a matching contribution of $3000. On top of that, you contributed $3000 to an individual retirement account and banked another $3000 in your savings account. Your total savings for that year, then, were $15,000 (total 401(k) contributions + IRA contributions + non-retirement savings).

Divide that number by $69,000 (take-home pay + total 401(k) contributions), and you get around 0.217, or a 21.7% personal savings rate. If you consistently maintain that rate over the course of your career, retirement savings with an 80% income replacement ratio shouldn’t necessitate a reduction in your current standard of living. An annual personal savings rate that is consistently lower than 20%, however, should tell you that you need to either rein in your expenses or use a higher income replacement ratio in your retirement planning.

Planning for Your Expenses

Now, let’s say you earn $100,000 in your final year of employment. If you’ve managed to maintain a steady personal savings rate of around 20%, you can probably anticipate that your annual expenses–barring any significant change in your health–will continue to be around $80,000 per year during retirement. According to BTN Research, you will need to have $196,000 in savings for every $1000 in monthly expenses over the course of a 20-year retirement; $269,000 in savings for every $1000 in monthly expenses over the course of a 30-year retirement.

These estates assume an annual return of 5% on your investments and an annual inflation rate of 3%. Your $80,000 in annual expenses amount to $6,667 in monthly expenses, necessitating a retirement savings of $1,307,000 to maintain your standard of living for 20 years (about $200,000 more than the savings amount recommended in Aon Hewitt’s model); or $1,793,000 for 30 years.

Start Now, or Regret it Later

One last thing to consider: Your retirement number is generally considered as the amount of money you would need to have saved to support you throughout retirement—at the end of which (i.e. when you die), your savings are fully exhausted. If you, like most people, would like to leave something to your children, you will need to adjust your plans accordingly.

Obviously, the best way to meet your retirement goals is to start saving as soon as possible. Contributing to a 401(k) offers some of the best savings advantages–especially if your employer makes a matching contribution–but an individual retirement account gives you more financial security and a greater degree of control over how your savings are invested. The best savings plan will likely use both. Either way, your retirement is sooner than you think; and every day you put off saving for it, you lose an awful lot of pennies.

Tim Dewey is a literature professor and freelance writer living in Minneapolis, MN. He is currently on track to retire at 113 years old.


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