One of the biggest mysteries the average working adult faces when it comes to their personal finances is knowing what the right answer is when it comes to the question of HOW much they should be saving every paycheck for retirement? We’ve all seen generic articles that say to save 10% or whatever, but how do we know that percentage is really the right number to plug into our personal retirement formula?
Even if you did take the time to figure out how much money you’d need and what size nest egg to save for, how do you know what chances your savings target would have of surviving another economic downturn like we had this past decade? What confidence do you have that the number you pick will result in your savings being able to last through thick and thin?
Pfau’s Suggested Savings Rate:
I was delighted this month when I received my new copy of Money Magazine for two reasons: 1) The cover story featured one of my favorite personal finance topics: Retirement planning. 2) That cover story “Six Secrets to a Dream Retirement” was based on the work of retirement income professor Dr. Wade Pfau of the American College.
Dr. Pfau has graced a few posts on My Money Design in the past with a few of his comments and perspective on retirement planning. In case you’re interested, here they are:
- Is 2 Percent the New Retirement Safe Withdrawal Rate?
- Be Careful With The 4 Percent Rule for Retirement Withdrawals
So what was so great about this article from Money Magazine? Only the fact that it solves our dilemma above by giving us a magic number to shoot for in terms of a “safe” savings rate:
“Wade Pfau, professor of retirement income at the American College, which trains financial planners, has crunched the number to find a safe level of saving that would have worked in every historical market stretch going back to periods beginning in the 19th century. He found that setting aside 16.6% of income and putting it in a diversified portfolio of stocks and bonds did the trick every time.”
Read that statement twice if you have to.
This gives us two very important points:
1. Not only does 16.6% represent a number that would help us hit our retirement income goal at ANY income level, but it was tested over various periods of time throughout the last century. In other words, if you had lived anytime between 1870 and 1980 and saved 16.6% of your income for 30 years, you’d be enjoying your retirement despite whatever economic event occurred. That’s a very powerful finding!
One caveat to keep in mind is that this savings rate was only good for your retirement formula as long as you plan to work / save for 30 years and then plan on only needing 30 years of retirement income. If your situation varies from this, then a different savings rate would most likely apply.
2. The good news though is that Dr. Pfau’s savings rate is designed to achieve a target retirement income level that is independent of some withdrawal rate like the suggested 4%. Basically as long as you save 16.6% for 30 years, you should have no trouble hitting your target income.
Testing 16.6% in Your Retirement Formula:
As you know on My Money Design, we like to crunch the numbers and put these kinds of theories to the test.
Even though Dr Pfau is not a fan of conventional retirement figures like the 4% withdrawal rate and 8% annual return, we’ll use these simplified values to put together a layman’s example and see what kind of results we get.
First let’s pick a concrete income level to use for our example. I’ll pick the round median income in the U.S. and go with $60,000 per year.
Now that we know that, we’ll need to calculate our target retirement income. Dr Pfau’s research puts this target at an inflation adjusted 50%. Performing an FV calculation using 3% as the inflation rate, we then get our target retirement income: $72,818.
If we use the conventional portfolio return assumption of an average annualized rate of 8.0% over the course of the 30 years, then our 16.6% annual savings rate would achieve the following result:
Success! As you can see, by the time we hit 30 years, our nest egg would reach a level that both produces our original desired target income as well as exceeds the conventional 4% withdrawal target. Regardless of which target you were trying to hit, you’ll finally have enough money to finally retire!
If you’re interested in the technical details as to what I used to calculate this retirement formula, here they are. If you don’t care, then just skip this section.
- Because our target income was already adjusted for inflation, I did not subtract away inflation from the annual growth rate.
- Salary and target income figures are gross (before taxes)
- My test assumes your salary will grow by 3.0% each year (such as the case with an inflation adjusted employer raise)
- I also assumed your employer would kick in a 2% contribution towards your retirement on top of your 16.6% savings rate.
The full summary of Dr. Pfau’s research is posted on his Retirement Researcher Blog. Click the Safe Savings Rate post to explore how he came up with this number in much greater detail.
Another Way to Test Your Plan:
If you’d like another fun way to see whether or not you’ll run out of money during retirement, a method I like to try is a Monte Carlo analysis. This is basically a simple simulation where the stock market return for each year is randomly generated. We can then use it to create various scenarios and see how long our money will last until we deplete it. You might be surprised by what you find!
You can download the Monte Carlo simulation I created in this Excel worksheet at this post: A Better Way to See If You’ll Run Out of Money During Retirement.
If Dr Pfau does get a chance to visit my site, I’d also be interested in hearing what he thinks of my retirement plan found in the post My Money Design for How to Achieve Financial Freedom – November 2012 Update. It’s a lengthy and tailored post to my own personal situation, but I think it is beneficial to others because serves as an example of a plan that brings together every retirement strategy I can think of into one executable model. All opinions are welcome.
Readers – What do you think about this safe savings rate? Would it work in your retirement formula, or is there something that would cause you to shoot higher or lower?
Image courtesy of digitalart / FreeDigitalPhotos.net