digging deeper

Systematic Investing- T. Rowe Price

Many investors find it challenging to determine how much to contribute toward their retirement goals. Participating in a workplace savings plan and contributing to an IRA are important steps in the right direction. A recent
T. Rowe Price study1 showed that about nine in 10 workers surveyed with access to a 401(k) plan contribute to it. But two-thirds of those surveyed save less than 10% of their salary, and about one-third were unsure of how much they contribute.

"The amount you save will have the greatest impact on your standard of living in retirement," says Judith Ward, CFP®, a senior financial planner with
T. Rowe Price. "And, unlike market and investment performance, you have complete control over your contribution amounts."

Exactly how much you need to save depends on your particular vision of retirement. A good rule of thumb suggests planning to replace 75% of your preretirement income in order to maintain your current lifestyle once you retire. Social Security and other income sources will provide some help, but you are likely to need to replace at least 50% of your preretirement income from your retirement savings. To reach this goal, most investors must save at least 15% of their salary for most of their working years.

An annual contribution rate of 15% may seem difficult to achieve. Bear in mind, however, that it includes any employer matching contribution. If your savings rate lags this target even after an employer match—or if you don't receive one—consider the following three steps.

1. Increase saving gradually. Whether you are starting at a contribution rate of 3% or 10%, the key to reaching 15% is to begin increasing your contributions now. Check to see if your employer's retirement plan provides an option to sign up for automatic increases to the percentage you contribute. If so, consider setting your contribution rate to increase by two percentage points each year until you reach 15% or greater. Likewise, you can take advantage of any pay increases to set aside more money.

Why it works: By setting your rate to increase automatically, you don't have to think about it, and it removes emotion from the decision to boost your savings.

Define Your Savings Goal
This chart shows the percentage of salary you should be saving, in combination with contributions from your employer, to maintain your current lifestyle in retirement. Across the top is how much you've saved as a multiple of your current annual salary. Your age is in the column on the left. Where the columns intersect gives you a target of how much you should be saving for retirement.

Define Your Savings Goal

Source: T. Rowe Price.
Assumptions: Your salary increases 3% annually; Social Security and other sources (like wages and a pension) make up 25% of your preretirement salary; you earn 7% on your investments in a tax-deferred account; and you retire at age 65. When you retire, the chart assumes your initial withdrawal amount will be 4% of your balance at that time.

The earlier you can begin to contribute 15% of your income to your retirement savings, the better your chances of reaching your retirement savings target. Gradually raising your contribution rate and taking advantage of catch-up contributions ultimately can help you reach the goal of replacing 50% of your preretirement income.

Define Your Savings Goal

Assumptions: Salary of $50,000 annually adjusted to anticipate a 3% inflation rate. Annual rate of return is 7%. Contributions not to exceed IRS 2013 annual limits of $17,500, with $5,500 in annual catch-up contributions when eligible. Replacement income represents the percentage of salary that will be replaced if an investor withdraws 4% of his or her retirement balance at age 65. This example is for illustrative purposes only and not meant to represent the performance of any specific investment option.

2. Use time to your advantage. Consider that if you contribute $500 a month at a 7% average annual return, you would save over $600,000 after 30 years. If you delay getting started by just five years, you'll have to increase your monthly savings to about $1,225 to reach the same amount. That's why it's important to start saving—or to contribute more—right away, no matter your age. "Don't delay," Ward advises. "Enroll in your workplace plan as soon as you're able, or start contributing to an IRA as soon as you have earned income."

Why it works: Through the powerful effects of compounding, your contributions generate returns that are reinvested, potentially producing even greater returns. Staying invested and contributing regularly can significantly increase your assets over time.

3. Catch up when you can. As you near retirement, you have the opportunity to increase your contribution amount beyond the IRS limits imposed on younger workers. For 2013, starting in the year in which you turn age 50, you can contribute an additional $5,500 annually to your workplace plan and an additional $1,000 to an IRA. If you are behind on your savings goal in the final years of your career, these catch-up contributions offer a critical tool to potentially help you gain ground. "You will be spending down these assets over decades," Ward says, "so contributions you make even in the late innings can be a big help if you have fallen behind."

Why it works: Catch-up contributions come at a time when most workers are in their peak earning years and can afford to divert more to retirement savings.

The earlier you start saving for retirement, the more likely you'll be able to accumulate the savings you need. If you can't reach the 15% target right away, consider making automatic increases to lessen the impact on your household budget. Also consider directing any additional funds—such as a raise or bonus—straight to your retirement savings, either as a lump sum into an IRA or by increasing your contribution rate to a workplace plan. This way, you will be able to save more for retirement without making your efforts feel like too much of a hardship.

1T. Rowe Price Harris Interactive Survey, October 17, 2012; Employee Benefit Research Institute (EBRI),
2012 Retirement Confidence Survey.

illustration by KEN ORVIDAS
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