Spoiler alert: probably more than you are

Mitchell Barr, Client Associate

How did we get here

Throughout our financial journeys, we have to ask ourselves, am I saving enough? Historically that wasn’t the case. My grandpa was a good old boy. He grew up in West Virginia, had a sixth-grade education, and eventually landed in Ohio where he worked for Chrysler in an auto plant for most of his career. He knew next to nothing about investing, and that was okay because when he retired, he had a pension waiting for him that paid 60% of his pre-retirement salary. It still pays that amount to my grandmother since his passing. Combined with Social Security payments, he ended up with a lifestyle better than what he had before retirement. This is the way many of the Greatest Generation and some Boomers have been able to retire. Work your butt off and stay with the same company for 30 years and you are set.

All that has changed, as pensions have been replaced by 401(k)’s. Poor management of pension funds by corporations and governments, over-promising benefits, and poor investment performance resulting from the burst of the Tech Bubble and the Great Recession have rendered the pension system in very poor health. According to the American Legislative Exchange Council (ALEC), unfunded pension liabilities nationwide exceeded $6 trillion at the end of 2017 (and that is just the state-sponsored pension plans). For context, the national debt currently stands at around $21 trillion.

The legislative solution to the failing pension system was the 401(k), a once-obscure section in the tax code which allowed employers to transfer the responsibility of making contributions and managing the investments in a retirement plan from the employer to the employee. Now instead of working for 30 years and knowing you could retire comfortably, most everyone is responsible for their retirement, whether they know anything about money or not. Is it a surprise that we are facing a retirement crisis?

Where are we now

Most of us now have the experience of enrolling in our company 401(k) plans when we start a new job. For “non-finance” people (basically everyone), the process usually breeds anxiety and uncertainty. The first hurdle is your investment choices, which often provide little to no explanation of what they are except some historical performance numbers and a general category. Many plans have transitioned to selecting investments for you based on your risk tolerance and estimated retirement date, or offer a financial professional to walk you through the different options. Those are both good things, and they make at least that part of the process manageable.

You also have to decide how much to contribute to your 401(k), which again causes many people to freeze with anxiety, procrastinate, or prevents them from enrolling in the plan at all. Automatic enrollment into 401(k) plans is one tool that’s been implemented by some employers to combat this analysis paralysis. When you get hired, a 401(k) account is opened automatically, and the plan elects a contribution rate for you. A recent Wall Street Journal article described this process:

“Today, more than 40% of companies with 401(k) plans set initial contribution rates under automatic enrollment at 3% of salary, according to Vanguard Group. Many gradually raise the level to 10%, often to coincide with raises, unless an employee chooses otherwise.”1

So, should you just let automatic enrollment take over and do nothing? If your employer is one that gradually raises the contribution rate, you will top out at saving 10% of your gross income (or $18,500, which is the maximum annual contribution under the IRS code). Is that enough for you to reach your retirement goals? That’s what we need to find out.

The “10% rule” has been a standard that has been bandied about over the years as some magic number, but the reality is there is no magic formula because every person has a unique situation. Consider your life’s variables:

  • How long will you live? Some people live longer than others. Do you have to plan for a 15-year or 30-year retirement?
  • How much money are you going to make in your lifetime? Who knows? You might be the next Jeff Bezos.
  • How will the stock market perform over the next 30 years? Let me get out my crystal ball.

These questions make figuring out how much to save incredibly complex. Pension plans use actuaries and have some of the smartest financial minds available to them, and they still can’t get it right. Saying that saving 10% of your income is the magic number is like aiming at a target blindfolded and hoping for the best. So, is it hopeless? Not quite.

How much is enough?

We can take a hint from Social Security to figure out “how much is enough?” Though there are questions about the Social Security’s stability (the program dipped into its trust fund this year for the first time since 1982), we will cross our fingers that it will continue to exist (and I believe it will, albeit with some adjustments). Many rely on Social Security to catch their retirement savings’ shortfall, but Social Security was never designed to be the primary source of retirement income. It explicitly says on the first page of Social Security statements:

“Social Security benefits are not intended to be your only source of income when you retire. On average, Social Security will replace about 40 percent of your annual pre-retirement earnings. You will need other savings, investments, pensions, or retirement accounts to live comfortably when you retire.”2

This little nugget of information helps. If you are content with living on 40 percent of your salary when you retire and are confident Social Security will be around, then don’t worry about saving. Many of us, however, want to maintain our same level of income in retirement, if not more. Social Security tells us if we’re going to do that, we need to have enough saved to produce the other 60 percent of pre-retirement salary when we retire. This rule won’t hold for everyone. You might spend less as you get older as expenses such as dining out and entertainment decrease. Alternatively, you might spend more if your medical costs go up. We can assume that you will need to replace 50 to 70 percent of your pre-retirement income if you want to maintain the same lifestyle into retirement.

That brings us to a new roadblock: how much is that in dollars? Nobody knows what their income is going to be in the year before retirement because it’s in the future, which means we don’t know how much income we need to replace with saving. So we don’t know how much we need in dollars. Fantastic.

Dr. Wade Pfau is a well-known retirement researcher who attempted to solve the problem of figuring out how much to put into your 401(k) today, without having to predict all these variables about the future that we don’t know.3 His idea was to look at history to see how much a person needed to save each year to not run out of money in retirement. The result was the “safe savings rate,” which is the percent of your gross income you would have needed to save each year depending on how long you save, how long you are retired, and the historical return on investments.

Although he uses some simplifying assumptions, the resulting chart below of safe savings rates gives us a guideline to answer the question, “how much should I put in my 401(k)?” And while his findings are not a silver bullet, they are much more helpful than choosing a random amount and hoping for the best.

Here’s how to read the chart:

  • The “accumulation phase” in the far-left column is how many years you save.
  • The “retirement phase” is how many years you will be retired (the average retirement is 18 years, but people are living longer. I expect I will live to approximately 125).
  • There are three different investment portfolios listed, with a “60/40 Fixed Asset Allocation” meaning that your savings grow at the historical rate of a portfolio invested in 60 percent stocks and 40 percent bonds.
  • Finally, Dr. Pfau looks at how much you need to save to replace 50 percent of your final salary in the top section and 70 percent in the bottom section.

As an example, focus on the top section to replace 50 percent of your final salary. Focus on the middle column for a “60/40 Fixed Asset Allocation” and then the sub column under a “30-year retirement phase.” If your accumulation phase is 30 years, a safe savings rate historically was 16.62 percent of your gross income per year!

Wade Pfau

Source: Wade Pfau

If you continue to look at different scenarios in the table, you will notice that many of the historical “safe savings rates” are well over 10 percent. That means automatic enrollment into your 401(k) plan won’t get you to where you want to be in some cases. One factor reigns supreme above all in lowering your savings rate —TIME! The earlier you start saving, the easier it is to have a comfortable retirement. Not only do you save for longer, but your investments have more time to compound. The effect of compound interest might as well be the eighth wonder of the world, but it only works if you leave the money alone. The savings rates work on the assumption that the money you save is set aside in a mental bucket that is absolutely off limits until retirement so you don’t dip into it when “life happens.” Sticking your hand in the cookie jar along the way will only require you to save more.

Although these savings rates may look discouraging or unattainable, there are a few things to keep in mind:

  • Savings rates don’t account for any retirement savings that you already have. If you are mid-career, you might need to look back at what you contributed to your 401(k) in the past to see if you are on track with Dr. Pfau’s safe savings rates.
  • Most companies match employee contributions, which counts towards the rate that you are saving in the table. For example, if your safe savings rate is 12 percent and your employer has a 50 percent match, you only need to save 8 percent of your salary, and they kick in the other 4 percent.
  • The savings rates assume your salary only grows at inflation throughout your career. In reality, you might make a lot more money later in life, which will allow you to make up any shortfall in your earlier working years.
  • The amount you save doesn’t have to go exclusively to your 401(k). Your bank accounts, IRA accounts, and any taxable investments count as well. In fact, your most significant savings vehicle may be right over your head, your home. Although it’s not as easy to turn your house into income when you retire, downsizing or a reverse mortgage can provide extra income in retirement to supplement what’s in your 401(k).

If you can’t fight the itch to have a concrete savings goal in dollars, you can plug in the savings rates above along with your salary to any number of retirement calculators. Bankrate.com has a robust calculator that will allow you to toggle the numbers to your heart’s content. At the end of the day, though, we will never know for sure if we are saving enough for retirement because the level of uncertainty in life is so high. My philosophy is simple: If you do all the right things (like reading this article) and you have the right attitude, whatever you have in the end will be enough. It will have to be enough. Start saving and let the markets do the work for you so you can stop worrying and enjoy your life.

    1. https://www.wsj.com/articles/five-ways-to-improve-401-k-s-1529460601
    2. Note: The 40 percent average only applies up to a certain income level because social security is capped. In 2018, the maximum attainable benefit for a person who delays receiving benefits all the way to age 70 is around $44,000 per year. If you make more than $110,000 in today’s dollars in your final year before retirement, the replacement rate of social security benefits will likely be even lower than 40 percent.
    3. Pfau, W. (2011). Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle. Journal of Financial Planning. Retrieved from https://www.onefpa.org/journal/Pages/Safe Withdrawal Rates A New Approach to Retirement Planning over the Life Cycle.aspx

Mitchell Barr

Client Associate

Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.

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