I've been thinking about retirement planning recently, and I have a retirement model for Meghan and I that I update annually. But I was thinking about creating a general retirement model as I found out some interesting things.
Pass this along to anyone you know in college or just starting out in the workforce:
The "secret" to retirement is to save 10% of your income (before taxes) every year. For example if you make $40,000 per year out of college - save $4,000 per year or $333 per month. This also means that as your income increases, your savings must increase as well to stay at 10% of your total income.
Let's look at the model:
The reddish line (sorry I have Office 2007) represents income per year. In this scenario it starts at $40,000 per year at age 23. As you can see at age 65 the income stops. That's why we are saving for retirement. After 65 (assuming that's when you want to retire) we need to live off savings. (In terms of retirement 65 is the new 55).
The short teal-ly blue line way below out income is our annual savings (10%).
The more smurfy-blue line that quickly jumps off the page is our retirement balance which thanks to compounding grows exponentially with each years of savings and growth. As you can see when our income stops - we live off of this smurfy-blue line which eventually crashes to zero at 90.
The pumpkin orange line is the growth of our retirement each year. As you can see - it quickly becomes a meaningful force working for our retirement. After about 10 years of saving - the growth on our savings contributes as much per year to our retiement as we svae from our income. It's like an additional employed member of the family saving 10% of their income for you! (only better because they don't spend any money). As we spend our retirement after age 65, the growth of our savings declines as we withdraw money to live on, and it to crashes out at 90 in this model. (It looks like it crashes a year after our retirement savings is depleted but that is just an artifact of my lazy annual compounding versus monthly).
The frog green line starting at 65 is social security. The reality is 23 year-olds today won't be eligible for full social security until 67, however you can take a reduced amount starting at 62, this model is somewhere in between. It may also be a leap to say there will be any social security in 30 years or so.
The plum purple line (not shown) are living expenses after retirement which are all below the x axis (negative). 80% of pre-retirement income is a "rule of thumb" that factors in empty nest'ers and possibly paying off your mortgage by that point as well as averaging the fact that you may be more active in retirement at 65 but slow down your spending by 90.
OK - so this isn't earth shattering - but I learned some interesting things running this model.
- It doesn't matter how much money you make - the 10% rule still holds
Let's look at a starting salary of $20,000
Or a starting salary of $100,000
Now for some quick examples of compounding. If you were able to save just 14% of your salary (or $466 per month starting with out $40,000 salary example) then you would not only be able to retire, but live off the interest of your retirements and never touch the principle. Therefore your retirement fund will "last forever" and you can pass on a huge sum to your children (in this example $5,600,000). This difference isn't far from just giving up cable each month (watch TV on hulu.com instead).
14% savings model
If you only save 5% per month (every month) then your retirement savings will only last until you are 75 in this model - or just 10 years after retirement.
Another compounding example - if the return on our investments nets 10% per year rather than 8% then 5% savings per month would last until 90 and therefore work for this model.
This is not a "crazy" scenario as the S&P500 index has returned 10% per year for the last 30 years. However the S&P500 has also returned 0% over the past 10 years and -5% for the past 3 years. Long story short - relying on 10% growth is not recommended.
So if you need to save 10% of your salary per year - what about 401k matching? If you are lucky enough to have an employer who matches your 401k savings - The most common is a 50% match up to 6% of your salary - or a 3% contribution to your retirement - reducing your burden to 7% per year.
Some Personal Notes
In addition to saving for retirement on our own - Meghan and I are fortunate enough that P&G has a profit sharing program. It's one of those things you don't think anything about when looking for your 1st job, but later makes a big difference. P&G's profit sharing doesn't require you to save any money for retirement (like a 401k match does). P&G just contributes money to your retirement. It starts at 5% per year and increases almost 1% per year of service to a max of 22% of your salary per year after ~17 years. P&G's contributions are made in P&G stock and remain as P&G stock until you turn ~50. Can you imagine - they do this for EVERY employee. It is remarkable!
So is that it then? Just have P&G contribute money for my retirement? Well I know folks who retired recently without saving a dime of their own for retirement and retired with quite a sum. However over their careers P&G stock had returned 16% annually. I am skeptical that the next 30 years will yield as much growth - but everyone who recently retired tells me they felt the same way when they started with the company - so who knows.
Another "artifact" of working at P&G is that it seems quite challenging to be employed past 55 - and 65 might be unheard of unless you are an executive.
Let's look at our original retirement model when saving 10% per year trying to retire at 55
Yikes! We only make it to 66 with our savings! In fact - if you crunch the numbers, in order to retire at 55 - you must save almost 20% of your salary every year (19.5%)! Or $650 a month for our $40,000 salary example.
Here's the 19.5% annual savings model
So what's the point of all of this?
- You will likely live longer than you can work.
- You need to save enough money during your working years to cover your expenses after retirement
- Saving for retirement isn't easy - but your need to do so doesn't change
I know some folks who start working at P&G and plan to save for retirement "later". They say it's hard to start out with their pay check and save for retirement. They assume their income will grow and eventually they will be able to save. Of course things will get in the way later as well, like buying an engagement ring, paying for a wedding, buying a house, having kids, etc. And the longer you wait to start, the more money you have to save.
It all comes down to 10% per year - every year.
I wish you all the best of luck with saving for retirement!
APPENDIX: Retire at 65 Assumptions
- You are living off your parents from Age 0-18
- After 23 you live within your means to pay back any student loans while still saving 10% annually
- Save 10% of income before taxes annually starting at age 23
- Retire at 65
- 8% annual growth rate (S&P500 10.34% annually over last 30 years)
- 3% annual inflation
- 4% pay increase annually
- Spend 80% of salary at time of retirement
- Assume you actually get Social Security
- Lifespan of 90 wonderful years