Retirement is such a complex goal because it means something different for every individual.
Someone looking to retire at 55, move to the beach, and take multiple lavish vacations a year will need a heck of a lot more saved than someone looking to retire at 60 but who continues to work part-time and simply maintains their current lifestyle.
The ability to retire boils down to your ability to fund your lifestyle with your savings. The higher your lifestyle, the higher your savings need to be.
The 4% Rule
The 4% rule is a general rule of thumb in personal finance originated from William P. Bengen which concludes that you can safely withdraw 4% of your portfolio each year for at least 30 years with a low likelihood of running out of money.
For example, if you have $1,000,000 in savings, you can safely withdraw $40,000 every year for the next 30 years and not run out of money according to Bengen.
Of course in order to determine your maximum safe withdrawal rate you would also need to include any income sources expected in retirement.
Let’s look at the case of a retired married couple, ages 65, with $50,000 in combined annual social security benefits and $1,000,000 in savings. Using the 4% rule, this couple would be able to fund a lifestyle of ~$90,000 every year in retirement ($50k from social security + $40k from savings) for the next 30 years and maintain a safe withdrawal rate.
However, if this couple is used to a lifestyle of $110,000/year prior to retirement, they would need to withdraw $60,000 from their savings to meet this lifestyle. This puts their withdrawal rate at 6%, presumably too high to sustain a safe retirement.
Conversely, assume this couple is used to a lifestyle of $75,000/year prior to retirement. After social security, they would only need $25,000 from their savings to fund their retirement expenses, a withdrawal rate of only 2.5%. This means they may have more savings than they need, thus allowing them to either increase their spending a bit more in retirement (travel, etc.) OR this may allow them to retire before age 65 as their savings can fund additional years of retirement.
How does this relate to savings rate?
Your savings rate is calculated based on how much you save in relation to your gross income, which is your income before taxes.
If your pre-tax income is $100,000 and you are saving $15,000/year, your savings rate is 15%.
While no two plans are the same, the more you save, the lower your lifestyle is, and the less income you have to replace in retirement. A person saving 25% only uses 75% of their income to fund their lifestyle. A person saving 5% is using 95% of their income to fund their lifestyle. Which is going to be easier to replace in retirement?
I’ve seen folks with $3,000,000 saved run out of money by age 80, and I’ve seen folks with less than $500,000 saved actually have MORE money at 80 than they did when they retired. It’s all about what income are you trying to replace in retirement.
What savings rate should I have?
Your savings rate is unique to your life stage, financial circumstances, and time horizon among many other factors, though a savings rate of 15% or higher is recommended.
But if you’re not there yet, don’t panic! First, determine your current savings rate. Then, make a plan to increase this over time. Some ways to help achieve this:
401k Auto Escalation
Many 401k plans come with a feature referred to as auto escalation. Basically auto escalation increases your 401k contribution by 1% every year until you reach the annual maximum ($19,500 for those under 50 in 2021). More than likely you will not even notice a 1% additional savings but this can provide significant benefit over time
Avoid Lifestyle Creep
Lifestyle Creep occurs when your standard of living continues to rise with your income. If you receive a 5% raise at work and increase your lifestyle by 5%, this is lifestyle creep. With each raise in pay, dedicate a portion toward increasing your savings and a portion toward additional spending. You are rewarding yourself both ways with this approach and avoiding lifestyle creep.
Automate Your Savings
Perhaps the first item you should address is automating your savings. Designate a certain amount to be saved each month/paycheck and then spend the rest, not the other way around. By automatically moving your money out of your available funds you take the temptation away to spend that money. You can automate savings into your 401k, IRA/Roth IRA, brokerage accounts, 520 college savings plans, savings accounts or any other savings/investment accounts you have.
Is it possible to save too much?
Possibly. If you sacrifice too much enjoyment today for the sake of saving money you most likely won’t need in the future, you may be saving too much. Read more in our article, Are You Saving Too Much?
Summary
While the 4% rule has been challenged in recent years with some proclaiming 4% to be too high, the concept provides a good framework on how to approach savings and ways to recognize if your savings rate is adequate for your goals.
If you have questions about your savings rate, your savings allocations, or if you are on track to achieve your goals, speak with a fiduciary financial planner who will put your interests first.
Andrew Langdon is a CERTIFIED FINANCIAL PLANNER™ and the founder of VetWorth, a fiduciary fee-only financial planning firm dedicated to serving the unique needs of veterinarians and their families.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.
