Rules of Thumb: How Much Should I Save for Retirement?
As a Certified Financial Planner™, this is probably one of the most common questions I receive. And it is not a very easy one to answer. In fact, the answer (as with almost everything in personal finance) is that it depends on the individual situation. Still, rules of thumb can be handy, so let’s consider a few commonly quoted rules.
Save 15% of your pre tax income.
This is an excellent guideline for a younger person looking to get started. Indeed, any individual who starts saving 15% of their pay early in their career and invests that savings prudently, will have a very high probability of retirement success.
However, there are some caveats. Older folks who are late to start saving will need to save at a faster rate to make up for lost time. Those with generous employer pension plans can probably get away with saving less. Those with generous employer matching plans can perhaps get by with less savings than those who have to save solo.
Save 8 (or 10) times your final salary.
This guideline looks toward the end result, rather than the periodic contribution. And in fact, the premise is fairly sound. Having retirement savings of 8 to 10 times your annual pay likely sets you up for a sound retirement. As with all rules, not everyone’s situation is the same. Those with higher expected retirement income can likely get by with less, those expecting no pension and lower social security payments may need to save more. Those who look forward to a more active retirement lifestyle need more savings than those who expect to spend their golden years as homebodies.
The primary flaw with this rule is that it is NOT very helpful to younger savers. After all, it leaves open the question of how much do you need to save to reach the desired level of savings. And how can anyone who is now 35 have ANY idea what their final salary will be? In contrast, the rule can be helpful to older savers within 10 years of their retirement date.
The 1, 3, 5, 8 rule.
Fidelity did a study suggesting that an individual aim to save 1 times his salary by age 35, 3 times by age 45, 5 times by age 55, and 8 times salary by age 67.
This rule provides useful guidance and milestones by which to gauge your progress, so is a bit more useful than the previous rule. It allows for the power of compounding, that as your investment pool grows in size, investment earnings will cause the nest egg to start growing faster.
A potential flaw in this rule is that it relies heavily on savings during the last stages of your career. While that is what most people actually do, it is also quite risky to rely on your earnings power late in your career. Older people who become unemployed often have trouble gaining employment, which could make it very hard to achieve retirement savings goals.
Consult a financial planning professional.
Rules of thumb are ok as a very rough guide. In fact - I prefer the term "guidelines" to rules, which imply a high level of confidence. As a result, rules of thumb are no substitute for a sound financial plan based on your own unique goals and financial situation. Seek out the services of a fee only Certified Financial Planner who can help you develop your own personalized retirement plan. Fee only planners can be found on this webssite or online at the National Association of Personal Financial Advisors (www.napfa.org) or the CFP Board of Standards (www.letsmakeaplan.org)