Saving for Retirement - Just How Much is Enough

How much do I need to save for retirement? Some variation of these words has been uttered by millions of Americans. People keep asking the question because the answers have been about as satisfying as an empty bag of potato chips. Investors have heard it all. Some experts advise people to save 10 percent of their paychecks, while even bigger naggers insist that older procrastinators need to set aside 15 percent or 20 percent or more. Others suggest that people save at least enough to capture a match in their 401(k) retirement plans.

Unfortunately, all this advice is overly generic and hardly applies to everyone. A 40-year-old who has been faithfully saving since her days as a babysitter, for instance, isn’t going to need to save as aggressively as someone who keeps QVC on her speed dial. A person who drives a 10-year-old Volvo and lives in a two-bedroom bungalow isn’t going to require as much in retirement as someone who tools around in late-model luxury cars and lives in a five-bedroom house that generates property taxes that are almost as obscene as the utility bills.

New Approach
It’s all these variations from the norm that explain why a new study, “National Savings Rate Guidelines for Individuals,” co-written by Roger Ibbotson, a professor at the Yale School of Management, should be invaluable to many anxious retirement savers. Five researchers involved in the study, which appeared in the April 2007 issue of the Financial Planning Association’s Journal of Financial Planning, developed savings guidelines for retirement that take into account a person’s age, the amount that has been saved, and his or her income. Individuals can use these guidelines to figure out how much they should be saving or whether they can relax and stop accumulating so many acorns. The study also provides targets on how much we should have stockpiled by the time we reach age 65.

In conducting the study, researchers focused on three areas:

• The cash flow needed in retirement.
• The savings needed to generate this cash flow.
• The annual savings necessary to build up the nest egg that, along with Social Security, will pay the retirement bills.

In developing their methodology, Ibbotson and the others developed an approach that others have failed to use. To calculate realistic savings rates, they didn’t peg their numbers on a person’s gross income—that is, what an individual takes home every year before taxes and other deductions eat it up. Instead, they keyed in on what they called the net pre-retirement income. They defined this as a person’s gross income minus whatever money he or she plowed into a 401(k), individual retirement account or other retirement plans for the year. This makes a lot of sense. Why should someone, for example, who makes $60,000 annually and saves 15 percent of that salary focus on replacing $60,000 when a $9,000 expense will vanish upon retirement? In this example, the aim would be to replace some percentage of $51,000.

One of the most intriguing sections of the study recommends savings rates for people as young as 25 and as old as 60. It starts off by looking at individuals’ current salaries. The study assumes that individuals will ultimately replace 80 percent of their net income and that they will work until age 65. To pull off that feat, a 25-year-old making $20,000 a year would need to start saving 5.8 percent of his salary. A 35-year-old earning $40,000 would have to begin socking away 12.1 percent.

Baby Boomer Prospects
But what about the numbers for baby boomers, people born between 1946 and 1964? According to the 2004 U.S. Census, there are 78.2 million baby boomers, about 9.1 million of whom are Black. Of the Black boomers, slightly more than 200,000 earn $100,000 or more.

In a report titled “The Retirement Prospects of the Baby Boomers,” the Congressional Budget Office notes that the approaching retirement of the baby boom generation has become a public concern, not only because of the budgetary pressures that will develop when baby boomers collect Social Security and Medicare benefits, but also because of claims that boomers are not accumulating enough private savings to finance their retirement. The report concedes that there is no widely accepted standard of what constitutes “enough” savings, mainly because retirement preparations are largely a matter of personal choice. However, it says, recent studies apply a range of different standards and provide a more complete picture of boomers’ finances.

According to those studies, compared with their parents at the same age, baby boomers typically have higher incomes, are preparing for retirement at largely the same pace and have accumulated more private wealth. “On the whole, boomers are on track to have higher income in retirement than their parents and appear much less likely to live in poverty after they retire,” the report says.

Within that overall picture, however, about a quarter of baby boomer households have so far failed to accumulate significant savings. They appear likely to depend entirely on government benefits in retirement. At the other end of the spectrum, at least half of the households are expected to maintain their working-age standard of living during retirement (under the assumption that current laws governing federal benefit programs do not change). For the remaining quarter of boomer households, the evidence is mixed: Under midrange assumptions about savings, rates of return and retirement age, they appear set to experience moderate declines in their living standard during retirement, which could be offset by modestly increasing savings and by working for a few more years. For many boomers, a relevant issue is the degree to which they could be affected by—and plan for—any future changes in federal retirement benefits.

Saving Early
The study by Ibbotson and his team reinforces the notion that saving early is just as critical as brushing one’s teeth and eating fruits and vegetables. Researchers note that the savings rate for 25-year-old workers typically more than doubles if they wait until age 45, and it triples for those who dally until age 55. Knowing that, it might not come as a shock that the savings goal for a 55-year-old earning $60,000 would be 32.6 percent.

But wait a minute. The numbers won’t look so bleak for baby boomers or anyone else if they have been feeding their retirement kitties. One table in the Ibbotson study shows investors how to shrink their savings requirement based on how much they have already invested. An investor of any age can reduce his/her savings percentage for every $10,000 she has saved. These deductions will vary depending upon a person’s age and salary.

Let’s look at our hypothetical 55-year-old, who would appear to need to live in a pup tent on a ration of hot dogs to meet his savings requirements. If our baby boomer had saved $200,000, his/his savings goal would drop to 18.6 percent a year. This calculation is based on a deduction of 0.7 percent per $10,000 saved. The deductions are greater for those making less money. For instance, the 25-year-old, who makes $20,000 and has $10,000 saved, could subtract 1.6 percentage points from his/her savings rate to make her new savings target of 4.2 percent.

Social Security’s Role
In the CBO report, nearly all of the studies reviewed assume that Social Security and other government benefits will be paid as prescribed by current law. However, budgetary pressures could result in lower benefit levels for some recipients in the future. Because baby boomers in the lowest quarter of income distribution are likely to depend on government benefits for nearly all of their income in retirement, their current prospects depend heavily on the future of Social Security.

Furthermore, people’s saving behavior is influenced by their expectations about future benefits, the CBO says. To the extent that baby boomers believe they will receive all of the government benefits to which they would be entitled under current law, that expectation may induce them to work or save less than they would otherwise. Conversely, to the extent that they recognize the looming difficulties in funding those programs, they may increase their savings or retire at a later age than they had originally planned.

Salome Kilkenny contributed to this story.

By Lynn O’Shaughnessy