A basic rule of thumb in retirement investing is that you should save at least 25X your desired retirement income.
Using the rule of 25, an investor who needs $100,000 in income from her portfolio must save $2.5 million to retire without the threat of running out of money. Younger investors will need to account for inflation in this calculation. Assuming a 3% inflation rate, an investor planning to retire in 30 years will need $243,000 to buy what $100,000 buys today. That means instead of saving $2.5 million to retire, this younger investor must save $6.1 million.
Calculating how much you must save to retire is of course the easy part. Getting there is the challenge. This is especially true today. With bonds offering yields of only 2.5% and the most ardent optimists acknowledging that stocks are priced to deliver annual returns of 5-6%, a balanced portfolio of stocks (50%) and bonds (50%) may struggle to achieve annual returns of even 4%. When bond yields were 5% and stocks were priced to deliver returns of 9%, investors could expect a 7% return on a balanced portfolio. That is not so today.
What is the difference between a 7% return and a 4% return? Let’s look at an example. Assume that Jane, a 50-year old investor, wants to retire in 15 years. Jane has $1,200,000 in retirement savings. She owns a small business that generates $150,000 in annual income. Jane wants to know how much she will need to save to retire with $100,000 in annual income.
To help Jane, the first thing we need to do is adjust her income needs for inflation. Assuming a 3% inflation rate, Jane will need $156,000 in income in 15 years to buy what $100,000 buys today.
Next we need to apply the rule of 25. One-hundred and fifty six thousand dollars multiplied by 25 is equal to $3.9 million. So Jane will need $3.9 million in retirement savings so that she can take $156,000 in income from her portfolio without running out of money. Since Jane already has $1.2 million in the bank, the $3.9 million savings goal is not out of reach. But in order to achieve her retirement goal Jane can’t rely solely on investment returns. She will need to make regular contributions to her retirement account. How much does Jane need to contribute?
This is where returns matter. If Jane was able to count on a 7% investment return from a balanced portfolio, she would only have to contributed $24,000 each year or about 16% of her income to reach her savings goal in 15 years. Today, with a 4% prospective return on the same balanced portfolio, Jane will need to save $84,000 per year to reach her retirement savings goal—that’s more than half of her annual income.
If you haven’t reassessed your retirement savings plan in light of today’s low prospective return environment, I would advise you rerun the numbers. You don’t want to spend your golden years waiting tables in a diner because you didn’t save enough during your working years.
Jeremy Jones, CFA
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