You have probably heard that question before and it is one similar to “What would I do if win the lottery?” as they are both very vague and expect no actual answer other than “it depends”.
However, let us try to frame that question from the perspective of a couple that is aiming at becoming financially independent and who are willing to prepare for the most important expense of their life : their retirement years. If you can figure out how to get prepared for your retirement, you will probably find it easier planning for intermediate expenses along the way (houses, kids education, …).
In addition to retirement being the largest expense to plan for, in many developed countries, the pension system is broke. Our financial savvy couple has better have a plan to have enough money when the time to retire comes, especially if they are currently in their 20s or 30s: there will likely be no retirement or nothing meaningful to support your life-style.
So don’t count on it and start building your own retirement pot.
How much money is enough money to retire?
In 1994, a retired financial advisor William Bengen first articulated the idea that in order to have enjoy retirement in the US for 30 years without running out of cash from its investments, one would need to limit its yearly withdrawals to about 4%. This became famous in 1998 when the Trinity Study was released and the “4%” rule became a rule of thumb to help people evaluate the amount of money they would need to retire. If you have a retirement pot of 1,000,000$, you can expect to withdraw an average of 40,000$ a year and live off of it.
The corollary of this rule is that you have an investment total of 25 times your yearly spend. If you currently spend a total of 60,000$ a year, you will need 1.5M$ (bear in mind this isn’t adjusted for inflation, if you plan on retiring in 30 years, this 1.5M$ of 2014 dollars will become close to 2.5-3M$ of 2045 dollars).
Your Savings Rate
If we push the analysis a little further and we take into consideration the yearly spend, the targeted 25 * yearly spend, we can estimate how many years of savings are required for a given Savings Rate. You will see the correlation in the graph below, based on a few assumptions:
- 100% of the savings are invested every year,
- the average return on investment is 8%,
- the starting wealth is 0$.
As an example, for a gross income of 100,000$, the net income is 73,000$ (after 27% tax) and a 30% Savings Rate is 21,900$, or the equivalent of 1,825$ set aside every month. If your company provides Discounted Stock Plan, Yearly Bonus, Housing,… those amounts add to your net income but also to your savings, therefore increasing your Savings Rate. If your company has a 401k you’re contributing to, the same method applies but you will need to consider the pre-tax nature of your contributions in your calculations.
You will note that to be able to retire at 67 if you have started to work at 24 (43 years of contributions), this model shows you will need around 7-8% of Savings Rate.
Now we have shown that our future quality of retirement is based on 3 variables :
- The expected Quality of your Retirement,
- The Time Horizon you have to build savings and investments,
- The Savings Rate that you can support.
Those 3 elements are interconnected: with a higher Savings Rate, you can expect a higher Quality of Retirement and conversely, a lower Time Horizon will necessarily translate into a higher Savings Rate (unless you can accept a lower Quality of Retirement).
The Time Horizon is pretty easy to figure out, the expected Quality of your Retirement is usually “at least as good as today”, so that leaves us with Savings Rate.
Of course, this model is not meant to be the answer to exactly how much Savings Rate is required for each individual to be plan for Financial Independence at or before retirement age, but is really meant to provide the tools and a baseline for everyone to plan today for an event possibly 30 years in the future. And this, today, is badly needed.
Here are some facts:
- The average Savings Rate in the US as of November 2014 stands at 4.4%, according to the Federal Reserve, one of the lowest rates since 1960. This is way below the estimated minimum 7-8% rate we calculated above.
- More than half of the US Household are “Financially Unprepared” for retirement in 2013, the highest level ever recorded.
Now, more than ever is a really good time to check spending habits, estimate retirement needs with 25 * spending and identify a Savings Rate that will help achieve a reasonably comfortable retirement.
And then, when we eventually retire, if the government’s pension system isn’t broke and we aren’t working till 80 years, we’ll be ready and we’ll consider ourselves lucky.
Dear readers, I am curious as to how many of you have managed so far to keep their Savings Rate above the 8% calculated above and if any has stories how they managed it?