If you are an average American, then you are probably not saving enough. As already discussed in my article on how your net worth compares, Americans are woefully behind in preparing for retirement.
Everyone should have the goal to achieve financial independence at some point in their lives. For some, it will be at 67, when they reach full social security and pension benefit age. For others, it will be at 35 due to their hard work, discipline, and maybe a little good luck.
The sad fact is that many people will never achieve financial independence at any age and don’t even have an idea of how much money they will need or even how far behind they really are!
The 4% Rule of Thumb
Planning for retirement may seem very complex, but it doesn’t have to be. While you’ll never know exactly how much money you will need to achieve financial independence, you can certainly estimate a number pretty closely and that’s where the 4% rule of thumb comes in.
Research has shown that based on historical stock and bond portfolio returns, withdrawing money from your investment portfolio at a rate of 4% the first year and then increasing that amount by the rate of inflation in subsequent years will give you a very high probability of that money lasting for 30 years. So, what does this mean to you and me?
You’ll need a lot of money to achieve financial independence. Do you think you’ll need to be a millionaire to retire? No…you’ll need to be a multi-millionaire! That’s depressing but true. Due to inflation, being a millionaire isn’t what it used to be. If you live in a high cost of living city, it’s very likely that unless you have a very generous pension and don’t start drawing social security until you are receiving the maximum, then you will need several million to retire.
Here’s the math using the 4% rule of thumb. If you want to live off $40,000 a year in retirement, then you will need $1,000,000 of investable assets. If you want or need to live off $80,000 a year in retirement, then you will need $2,000,000. Once you start receiving Social Security, you will not need to pull as much from your portfolio and/or if you have a pension from work or other passive income, that will help as well. Otherwise, the rest is on you and your portfolio.
I ran some numbers to illustrate the point. What’s interesting about these calculations is that the percentages work the same no matter how much money you make. In the example below, I used a household income of $100,000 for simplicity and a 5% real rate of return.
Using these assumptions, if you save 20% of your income, it will take you almost 36 years to reach your savings target at which time you will be able to maintain your lifestyle indefinitely. If your household income is only $50,000 or $60,000 or $70,000 and you save 20% of your income, it doesn’t make any difference, it will still take you almost 36 years to reach your savings target.
The amount you make doesn’t matter, it’s your savings rate that determines when you will reach financial independence. That’s why your savings rate is so important. Check out the table below for different savings rates:
Why Savings Rates Are So Important
Savings rates are so important because they not only indicate how much you are saving, but they are inversely related to your annual expenses. If you saved 20% of your income, then you spent 80% – common sense, right? You’ll see in the table above, that if you make $100,000 a year and save 10%, you are spending $90,000 a year.
If you make the same $100,000 a year and save 30%, then you are living off $70,000 a year. That’s a big difference and will get you to financial independence almost 23 years sooner. The big question then is, how much should you be saving?
Appropriate Savings Rates
The short answer for how much you should be saving is as much as you can. But in reality, we all have lives to lead and bills to pay. We want to enjoy dinners out with friends and family and maybe travel a little too, so you can’t save all your money.
Here’s my advice and what I would tell my kids or anyone else that asked. Start saving 20% of your gross income with your first job out of college. Put 10% in retirement savings or the minimum required to get the full company 401k match, if that is an option for you, whichever is greater.
Use the remainder of the 20% to save up an emergency fund and after that is funded, start saving for a down-payment on a house or apartment. If you have credit card debts or loans, then you should pay for that out of your other 80% and pay them down as quickly as possible. Save more if you can and still enjoy your youth!
Take your savings percentage up by 1% each year and you will be in good fiscal shape. If you’re already in your 30’s or 40’s, then you should be well north of a 20% savings rate by now and if you want to reach financial independence before traditional retirement age, I’d recommend you push it north of 40% to even have a shot at making it.
As part of our financial independence plan, we have been taking our savings rate up consistently for the past few years. In 2015 we were up to a 25% savings rate and I’m hoping to have it up to 30% in the next few years.
What is your current savings rate? Do you think it is high enough? What other factors should I include in my savings rate table to make it more helpful?