September 10, 2013
|Stuart Ritter, CFP®, a senior financial planner with T. Rowe Price, explains that saving less than you should for your retirement can mean a dramatic decrease in your lifestyle after you stop working.|
The first step is to understand how much income you'll need once you retire. Because you will no longer be paying payroll tax or saving for retirement, you should be able to maintain your lifestyle and cover your expenses with approximately 75% of your preretirement income. Fifty percent should be generated from your retirement investments, with the remaining 25% coming from Social Security benefits and other sources, such as a pension or part-time wages.
Most people need to save at least 15% of their annual income, including any employer contributions, to achieve the desired amount in retirement. (Your savings percentage may need to be higher if you're getting a late start or if you stop saving for a significant period of time.) Many investors believe they can't afford to spare this much money, even if they increase their savings rate by just 2% a year to reach the target. Contributing a small percentage of your income today can help significantly increase your potential to maintain your lifestyle throughout a retirement that could last 30 years or more.
Consider a hypothetical 25-year-old investor making $25,000 a year. She contributes 3% of her salary to her 401(k) plan every year and receives a matching contribution of 1.5% from her employer, for a total of 4.5% of her salary invested each year.* We'll assume she invests in a portfolio generating a hypothetical 7% average annual rate of return until retirement at age 65. We'll also assume that she will withdraw 4% of the balance of her portfolio at retirement, increasing her withdrawal amounts by 3% each year thereafter to account for inflation. With this savings strategy, the investor will only be able to cover 50% of her expenses in retirement, which means that she will have to cut her lifestyle in half after she leaves the workforce.
However, the investor's future looks much brighter if she starts by saving 6% of her salary for retirement (with the full 3% employer matching contribution, for a total of 9%) and increases the rate by 2% a year until she reaches a total of 15%. This revised strategy enables her to draw an annual income that allows her to maintain her preretirement lifestyle and cover her expenses. Please note that many employer retirement plans offer the option of auto-increasing savings to help keep you on track.
With competing financial priorities, it's tempting to make the decision to "ease up" on saving. Maintaining a proper savings rate—or increasing it if you're not there—is still important. To give you an idea what your lifestyle might look like with limited income in retirement, consider the actions you would have to take now if your paycheck were suddenly cut in half. To avoid having to make these difficult choices in the future, take action now to ensure your savings contribution percentage is in line with your goals.
*The employer matches 50% of the employee contribution, up to 6%.