So you're convinced that you need to be funding your 401(k) (if not, go read Part I). But how much should you invest?
Well, that's an easy one. You should invest as much as possible.
Ok, that's not really what you meant. What you really want to know is, how much do you have to invest in order to have a comfortable retirement?
The answer to that question is a little more complicated.
First off, we need to define what you mean by "a comfortable retirement". Do you plan to tour the world, or just catch up on all the good TV you missed? Often people use 80% of pre-retirement income as an estimate, but it really depends entirely on what you plan to do in retirement; call this the quality of life cost.
To determine how much money we'll need, we need to consider:
- Food
- Housing
- Medical costs
- Lifestyle choices (as mentioned above)
- Safety margin (how much risk we're willing to take that we won't have enough)
Once we know how much spending money we'll need each year, we can calculate how much we'll need to save to have it. This will involve a bit more guesswork, however, and only some of the factors are under our control.
At what age do you plan to retire?
This determines how long you have to save, how long that money has to grow, and how much you'll collect from Social Security: taking early retirement reduces your benefits significantly, while delaying retirement increases them.
How long do you plan to be retired?
You'll need a lot more money if you plan to live forever than if you're fine with being dead broke in 15 or 20 years.
How quickly will your investments grow?
Obviously this is impossible to predict, but we can make a guess based on past performance. From the beginning of 1871 (the earliest date figures are available) through the end of last year, the average growth has been 10.77% and the compound annual growth rate (the "real" return) has been 9.11%. However, after adjusting for inflation, that real return drops to 6.9%. The numbers jump around a bit as you adjust the dates, but the real inflation-adjusted return tends to stay between six and eight percent. Let's use 6.5% to be safe.
Keep in mind that this is, again, an average. The standard deviation (don't let your eyes glaze over - this will be short!) over that time was 18.62%; what that means is that 2/3 of the time the market's performance was somewhere between a 25% gain and a 12% loss; 19 years out of 20, between a 44% gain and a 30% loss. In other words - wild swings happen, and the order they occur in can have a large effect on your savings.
How high will inflation be?
We're actually going to cheat a little here. Rather than calculating inflation, we'll just take all of our numbers to be adjusted for inflation - that's why we used the 6.5% number for the market return instead of 9%, above. In other words, we expect the market to rise by 9%/year, on average, but we expect prices to rise by 3%, so we actually only get a 6% increase in spending power.
How high will taxes be?
I think it's safe to say that taxes will go up and down a lot over the next 30+ years. The final number will depend both on what Congress does and what your retirement income looks like compared to your pre-retirement income, as well as how much of it is taxable as ordinary income. We'll get into more details once we get to our example.
What are your sources of income?
If you'll be collecting social security or a pension, this obviously reduces the amount you need to save on your own. Additionally, the tax treatment of your savings can make a huge difference; $1,000 in a Roth account is worth a lot more than $1,000 in a traditional account if you're not in the lowest tax brackets!
Alice and Bob
So far this has all been pretty general; now let's work through some numbers. We'll follow a fictional couple named Alice and Bob as they sit down to figure out retirement for the first time. Alice and Bob are 30 years old and have no savings. They both work (for a combined household income of $50k/year), and in fact, will continue to make $50k/year (adjusted for inflation) for the rest of their careers. They have 2.4 children.
Step 1: Determining needs
Alice and Bob decide that they'd like to simply maintain their standard of living in retirement. They expect their living expenses to drop because they will have paid off their mortgage, will no longer have children living at home, and will no longer need to commute. However, they expect to have higher health care costs and would like to take up golf. So they set a goal of continuing to have $50k/year income in retirement.
Assuming that Alice and Bob both make $25k/year and will work until age 67, they will each qualify for $1,145 in monthly social security benefits (in today's dollars). This works out to $27,480 per year - about half of what they need to maintain their quality of life. So they'll need to generate the other $22,520/year from their investments.
Hint: if you have enough Social Security credits to qualify for benefits (40 credits, generally 10 years' worth of paying into the system) you can see your estimated benefit here, if you don't have enough credits yet, you can use this calculator. Because Alice and Bob will pay into Social Security for at least 30 years and start taking benefits at age 67, they will qualify for the full benefit.
Many members of both families lived to be older than 100, so Alice and Bob decide that they want their money to last indefinitely. A general rule of thumb is that they can withdraw up to 4% per year from their retirement funds without ever running out of money. Since they need $22,520/year from savings, that means they need $22,520 / 0.04 = $563,000 in today's dollars. (Of course, with inflation the actual number will be well over a million)
There are probably thousands of calculators on the internet that you can use to figure this out; I used this one. Starting from zero and investing for 37 years at a 6.5% return, it estimates that we need to deposit $304.75/month to reach the goal - a little over $3600 per year, or 7% of Alice and Bob's income. Because their income is remaining constant except for inflation, they'll invest the same amount (adjusted for inflation) every month over the next 37 years. Of course, if their workplace offers a match, that counts towards the required savings. Over 37 years, they'll save $135k and gain $427k in interest.
On the other hand, if Alice and Bob are worried about taxes going up, they could invest in a Roth account rather than a traditional account. If they put in $304/month, as before, it will actually cost them a bit more (because this is after-tax dollars); if they instead put in the same amount adjusted for taxes (that is, $304/month minus the taxes they pay on that money) then, while the amount they'll end up with will be smaller, if tax rates stay the same it will be exactly equivalent to what they would have had after taxes with a traditional account.
Keep in mind, these numbers make two big assumptions: that the market grows at approximately the same rate (or almost) as it has over the last 140 years, and Alice and Bob make approximately the same return as the market. In practice, as they start getting closer to retirement, they'll shift more of their money out of their index fund and into bonds or annuities so that they aren't affected if the market dips right before they need to take out money.
And if they want to travel the world? In that case, time to look for a new job; they may need to save a lot more...