Wednesday, April 20, 2011

In my May 2010 blog post, Your Retirement Goal, I provided some suggestions for determining how much you need to save and invest to enjoy a comfortable retirement. One of the conclusions of that post may have been more pessimistic than necessary, because I assumed that the amount saved each year was constant. An alternate assumption is that you will be able to save more each year (as your income increases), hopefully at least enough to match inflation. This assumption reduces the initial savings rate. In this post I show an initial savings rate based on the assumption of increasing savings over the years. I also provide a link to a Google Docs spreadsheet you can copy and use to do your own analysis.

Here's a recap of the assumptions and calculations in the original post (all rates and income figures are per year):
• Gross (before tax) income: \$60,000
• Years until retirement: 40
• Nominal investment rate of return: 6%
• Inflation rate: 3%
• Retirement income required: 70% of current gross salary = \$42,000 (today's dollars)
• Social security income in today's dollars: \$20,000
• Retirement income required from investment portfolio: \$42,000 - \$20,000 = \$22,000 (today's dollars)
• Investment portfolio withdrawal rate in retirement: between 3% and 4%
• Portfolio required at beginning of retirement, adjusted for inflation: \$1.8M - \$2.4M (I used \$2M, which corresponds to a portfolio withdrawal rate of about 3.6%)
Using these numbers, I calculated a required savings of about \$12,000 per year to reach the inflation-adjusted  retirement portfolio goal of \$2M, but as mentioned above, this assumed no increase in savings each year. If instead we assume that the savings rate increases at the projected inflation rate of 3%, then the amount that must be saved in the first year is about \$8,000 instead of \$12,000. This is about 13.4% of gross income instead of 20%.

The table below shows the first five years and last five years of contributions (savings) and portfolio growth based on the assumptions stated above (if you are reading this in email and can't see the table, either configure your email to display images, or use your browser to go to www.kevinoninvesting.com, and read the post there). Note that the calculations assume a contribution at the beginning of each year, whereas a more realistic assumption is that contributions will be spread throughout the year. Considering the uncertainties in the other assumptions, this isn't very significant.

One thing to keep in mind is that there are many reasons you may not be able to increase your savings rate to match inflation. The simple analysis done here doesn't factor in saving for major expenses such as a down payment for a house, or college for your children. So, I still think it's best to save at the higher rate (or even higher) in your early years if at all possible (and later years too).