Employment disruptions caused by the COVID-19 economic slowdown have scrambled the retirement saving strategies of many Americans. According to a recent survey, nearly half of employed Americans either reduced or suspended their retirement savings during the pandemic.
Moreover, around 30% of those surveyed reported being behind in saving for retirement. Looking on the bright side, at least those people had an idea of how much they needed to save. Unfortunately, many people’s estimates are based on faulty assumptions — including the misguided belief that Social Security will cover most of their retirement needs.
Assess Your Situation
The Internet is loaded with retirement calculators. But before you can use them, you need to address several key questions:
- What lifestyle are you aiming for when you retire? If you’re OK with reducing your current material standard of living, how low can you go?
- Do you intend to pass on an inheritance to loved ones and/or donate to favored charities?
- How long will you be willing (and physically able) to work before retiring? Beware: Some people may need to retire sooner than they anticipate for health or other reasons.
- How much investment risk can you handle? The offset to higher returns is usually greater volatility.
- Can you count on receiving a substantial amount of money from an inheritance, sale of a second home or other source?
The longer you postpone retirement, the less you’ll need to accumulate. It’s not just that you’ll have fewer years to live in retirement, but under current Social Security rules, each year you wait after you reach your full retirement age, 8% is added to the amount of your monthly benefit payment. (After 70, however, those increases stop.)
The higher your Social Security benefit, the less you’ll need to supplement it with retirement savings. Your Social Security benefit projection statement will help you with the number crunching.
Important: When evaluating whether you’re saving enough for retirement, remember that inflation can have a corrosive effect. For example, since 2000, the purchasing power of Social Security benefits has dropped by 30% due to inflation, according to a recent analysis by the Senior Citizens League.
Do the Math
Now it’s time to calculate how much you’ll need to set aside for retirement. To illustrate how this evaluation might work, suppose that Joan is currently 42, and she plans to retire at 67 (the full retirement age for people born in 1960 and later) with an income that’s 75% of what it is today. Further, suppose that she has an average risk tolerance, isn’t expecting any big financial windfalls down the road, and isn’t planning to leave a large legacy to her loved ones or favorite charities.
Using those assumptions, here are five basic steps Joan might follow to determine whether her savings plan is on track:
- Calculate 75% of current income. Joan currently earns $80,000; 75% of her earnings is $60,000.
- Estimate how much is needed to maintain her purchasing power in retirement. Joan expects to retire in 25 years. So, she’ll need about $126,000 per year (or $10,500 per month) to maintain the purchasing power of $60,000, assuming a 3% inflation rate. (This is the future value of $60,000 at 3% for 25 years, assuming annual compounding.)
- Subtract projected Social Security benefits and any private pension benefits. Joan estimates she’ll receive $5,750 per month from these sources. She’ll need enough in retirement savings to make up the $4,750 difference each month ($10,500 – $5,750). That’s the equivalent of $57,000 a year.
- Estimate the total amount of retirement savings needed. This step requires a figure known as a “safe withdrawal rate.” That’s the percentage of your retirement savings you can take out and spend each year. A simple actuarial rule of thumb is to divide your expected retirement age by 20. For example, Joan currently plans to retire at 67, so her safe withdrawal rate would be 3.35% (67 divided by 20). If you divide the annual retirement-savings income she’ll need (from the third step) by her safe withdrawal rate, you’ll arrive at a total savings amount of approximately $1.7 million ($57,000 divided by 3.35%).
- Subtract current retirement savings from the target amount to estimate how much more savings are needed. Joan currently has $700,000 in retirement savings, so her account is $1 million short of what’s needed.
Your financial advisor can help translate that figure into required monthly savings amounts based on the number of years until you expect to retire and the returns you can safely assume.
For example, to accumulate another $1 million in her retirement account, Joan would need to save at least $1,318 per month, assuming a 7% annual return for 25 years. That amount could be reduced if Joan’s employer matches her contributions to the company retirement plan.
It’s Never Too Late to Save!
People who are 50 or over at the end of the calendar year can make annual “catch-up contributions” to certain accounts to save more for retirement.
Here are some of the contribution limits for 2021 for those who are younger than age 50 and those who are older:
- Traditional and Roth IRAs, $6,000 ($7,000 for those over 50),
- 401(k)s, 403(b)s, 457s and SARSEPs, $19,500 ($26,000 for people 50 and up),
- SIMPLE accounts, $13,500 ($16,500 for people 50 and up), and
- Simplified Employee Pension Plan (SEP) accounts, $58,000 (there’s no SEP catch-up amount).
Whenever possible, it’s a good idea to contribute the maximum allowable to your retirement account to secure your future and get the full tax advantage.
This exercise will help give you a general idea of where you stand. It will also prepare you for a meaningful conversation with a financial professional who can sharpen the estimates and offer practical suggestions for reaching your goal.
Inevitably, there will be a wide margin of error with whatever number you come up with, especially for younger people who won’t retire for decades. In addition, taxes can play a significant role in your savings strategy. The effects will vary depending on your tax rate, and whether you decide to use a Roth retirement savings account, a traditional tax-deferred account or a combination of these alternatives. Contact us to help determine what’s right for your situation.