The Two Numbers to Learn for Retirement

By Will Carter
10/1/2009

Recent economic troubles have made it painfully clear that most people are not saving nearly enough to maintain their standard of living in retirement. 

Less clear is what to do about it. 

Some people want to fix the "system" – asserting that since the 1980s, government and big business have quietly reneged on past social security and pension commitments to provide people with sufficient income during retirement. 

Others blame our "values" for the retirement savings gap – asserting that Baby Boomer values and practices have created a live-for-today culture that spends money on conspicuous consumption that should be dedicated to retirement savings.

Both perspectives are valid, but neither will do much to help Baby Boomers manage the tight retirement funding situation they find themselves in, or to help future generations learn how to avoid ending up in a similar situation.

I suggest starting with a politically neutral focus – mathematics. 

More specifically, I believe that if Baby Boomers and their adult children will learn just two numbers – 4% and 30% – they will be much better prepared for retirement than they are today.

1.  The 4% retirement spending solution

The 4% number is most important for people in or near retirement, because 4% is the amount that experts agree can be distributed from a retirement nest egg the first year of retirement in order to have a reasonably high probability of maintaining the buying power of that distribution over a 30-year retirement.

For example, take a couple in their early 60s with $500,000 in retirement savings with roughly half stocks and half in bonds.  T Rowe Price's online retirement planning tool tells us that if this couple distributes 4% ($20,000) of their savings the first year of retirement, they have a better than 85% likelihood of continuing to make that distribution, plus inflation, over a 30-year retirement – even if the stock market drops during the first years of their retirement. 

The 4% number is a mathematically-based guidepost – not advice.  People who understand it can take more than 4% out of their retirement nest egg, but they should do so with the knowledge that that the higher the distribution above 4%, the higher the likelihood that they will have to reduce spending later in retirement.  For instance, a 5% first year distribution out of a retirement nest egg correlates to a less than 60% probability that funds will last 30 years.

2.  The 30% retirement savings solution

Unlike people in their 50s and 60s, people in their 30s and 40s are less concerned about how much they can prudently withdraw from future savings, and more focused on how much they should put into retirement savings.

Though this number is difficult to calculate with certainty, 30% of annual household expenses is a good place to start.   In other words, basic math, combined with the 4% solution described above, tells us that a young family spending $6,000 a month on recurring living expenses with no pre-existing savings should consider saving at least $2,000 a month for retirement.

The 30% figure is based on math models assuming that living expenses will increase 1% faster than inflation throughout a person's career, that Social Security will cover 25% of those living expenses, that taxes will reduce the value of retirement income and distributions by 10%, and that retirement savings will be invested and grow at 7% per year.  Though none of these assumptions are guaranteed to be true, they are reasonable estimates to start with.

However, these assumptions mean that the 30% retirement savings solution is too low for many people, like most highly paid professionals and executives who expect to substantially increase their cost of living over the course of their careers (e.g. bigger houses, bigger cars, fancier vacations) or who will have a higher tax on retirement distributions during retirement. 

Conversely, the 30% savings rate (as a percentage of household spending) may be higher than needed for young families who plan to maintain a consistent standard of living through their career, who are at or below average household income, and/or already have accounts dedicated to long-term retirement savings.

Both the 4% and the 30% numbers described above involve consideration of a third number that is unique to each family – namely, annual living expenses.  For most people, this is the most important number to learn, providing a foundation for determining the other numbers that will lead to a financially successful retirement.
 

Will Carter is director of wealth management for McKinley Carter Wealth Services (www.mc-ws.com), an SEC registered investment adviser with its principal place of business in the State of West Virginia. The information contained herein is general market information only and is not intended to be personalized investment advice.  Mr. Carter can be contacted at wcarter@mc-ws.com, 304-346-3700 or 866-306-2400.