April 17, 2013
|Christine Fahlund, Ph.D., CFP®, is a senior financial planner and vice president of T. Rowe Price Investment Services.|
Situations in your life may cause you to temporarily stop saving, but there are steps you can take to make up for lost time.
Many investors saving for retirement may at some point temporarily suspend their contributions for any number of reasons—losing a job, caring for children or an elderly parent, or coping with medical problems. But a lapse in retirement investing doesn't necessarily need to translate into lost retirement income. A recent study by T. Rowe Price analyzes the potential long-term impact on retirement income from saving interruptions and outlines how to get back on track. You never know when you may need to temporarily stop saving for retirement. But you can recover once the situation allows by adjusting your savings rate to compensate for the missed time.
The rules below will help you establish a framework for your savings goals—and can serve as a guide to help you progress toward reaching them.
Save enough. According to research by T. Rowe Price, most investors should follow this basic rule of thumb: Save at least 15% of your salary each year, including any employer contributions, over the course of your working years. At this rate, investors should be able to save enough to support themselves with withdrawals from their retirement savings, Social Security, pensions, part-time work, or other income over the course of 30 years, up to at least age 95.
Plan an income target. Plan to replace 75% of your income once you retire. For example, if you earn $70,000 pretax annually at the time of your retirement, you should aim to provide yourself with $52,500 pretax ($70,000 x 0.75) from all sources in your first year of retirement. We suggest the following breakdown: Replace approximately 50% of your salary—in this example, $35,000 ($70,000 x 0.5)—with withdrawals from your nest egg, and take the remaining 25% from Social Security and other income sources.
Don't withdraw too much. Research supports the wisdom of withdrawing 4% of your portfolio in your first year of retirement and increasing that amount by 3% for inflation each year thereafter. For example, if you have saved $1 million when you retire, you can withdraw $40,000 in the first year from your portfolio and increase that amount by 3% to $41,200 in the second year, and $42,440 in the third year. This approach provides a strong probability that you'll maintain the purchasing power of your withdrawals throughout retirement.
See how this strategy would work with an average annual pretax return of 7% and 3% inflation each year before retirement at age 65. Consider a hypothetical investor who makes $40,000 a year at age 30, receives a 3% raise each year, and saves 15% of his salary annually (including employer matches) toward retirement. He will accumulate enough money in his portfolio to be able to withdraw an amount equal to 48% of his preretirement salary at age 65, using the 4% initial withdrawal rule of thumb. (See Example 1 below.)
Young investors versus preretirees. Missing out on five years of making contributions to retirement accounts can affect savings dramatically. But the extent of that impact depends on the age at which contributions are suspended. Young investors have decades to make up for a few years of missed saving early in their career. By contrast, preretirees who miss a few years prior to retirement must save significantly more in order to catch up. The reason: With a short time horizon, the likelihood of the portfolio increasing in value is much lower than it would be if the portfolio could benefit from decades of tax-deferred compounding.
Consider Example 2 (below) in which an investor misses five years of saving, beginning his career at age 30 but not contributing until age 35. In order to replace 48% of his salary at age 65, he must contribute 20%—not 15%—of his salary for each of the next 30 years.
Compare these results with those of Example 3 (below), a preretiree who stops contributing from ages 55 to 60. This investor must contribute 34% of his salary in each of the following five years to achieve the same 48% replacement income goal. The investor who has 30 years to catch up (Example 2) only has to increase his contribution rate by five percentage points, whereas the investor with just five years to catch up (Example 3) must increase his contributions by 19 percentage points.
It is not uncommon for a young investor to start saving in his 30s or 40s, rather than in his 20s. Yet this study demonstrates that the sooner you start saving for retirement, the less "heavy lifting" you will have to do later in your career in order to achieve your retirement income goal. Starting to save as early as possible is one of the best ways you can prepare now for the unknown future that awaits you.
While saving may not feel particularly important for young investors, they may benefit from imagining their circumstances as they near retirement age. They may, for example, carry college education debt for their children and have a mortgage to eliminate before finally retiring. Piling those monthly obligations on top of an increased retirement savings rate may leave little or no discretionary income with which to take trips, make home improvements, or purchase a new car. And it may force them to push back their retirement date in order to maintain the lifestyle they want after they stop working.
Rather than being constrained by these competing obligations as retirement nears, young investors may be well served to start saving a little sooner to gain a lot more financial flexibility later. Saving early also helps minimize the impact of any periods in the future during which you may have to stop saving temporarily. You will have already saved as much as possible, so any lapse will have a minimal impact on your lifestyle in retirement.
If you take a savings hiatus late in your career, you'll need to make a significant increase in savings to achieve your salary replacement goal of approximately 50% from your nest egg. There are, however, other approaches to catching up that a preretiree might find more attractive.
1. Practice Retirement®. Continue working for a few extra years beyond age 65 but start retirement activities at the same time. As the name suggests, you can "practice" retirement while you continue receiving a salary and benefits. Delaying your retirement date means you won't have to make any withdrawals from your nest egg. At the same time, your portfolio has more time to potentially benefit from compounded, tax-deferred growth. It also means more years to delay taking Social Security benefits. Each year a preretiree waits, the initial Social Security benefit amount increases approximately 7% to 8%, plus a potential adjustment for inflation. A preretiree age 65 will receive a 32% benefit increase by delaying starting benefits until age 70—and could actually receive more after adjustments for inflation.
2. Revise your anticipated lifestyle in retirement. If you started saving for retirement at age 30 and have a savings lapse of five years between age 55 and age 60, you would be able to replace 43% of your salary, instead of 48%, assuming you continued contributing 15% each year instead of increasing the amount to 34% of salary for the final five years. Depending on the expenses you project for retirement, this reduced income might not affect your lifestyle significantly.
It's impossible to anticipate the events that may influence your ability to save consistently for retirement throughout your career. But you don't have to be able to predict what could happen in order to prepare for it and ensure that your financial life remains on track over time. Having to reduce or temporarily discontinue saving—whether it's for five months or five years—is sometimes unavoidable. If you want to prevent a break in savings from having a significantly adverse effect on your income in retirement, the approach is straightforward: Contribute as much as you can, as early and as often as you can.