One of the most common questions I get is “When can I retire?”. I’ve come to realize that by “retirement” most individuals and families are referring to financial independence, where they have saved enough to choose what they are working on and when. Coming up with this number is the core of financial planning for almost everyone not currently in retirement or financially independent. Luckily for us, financial planning, financial markets and life in general have provided us with the answer over the course of hundreds of years. The results are in and the clear winner in this debate is… it’s a complicated moving target.
The world changes so quickly and the rapid advancements in technology will further enhance the pace at which change and disruption enter our lives. There’s no way to tell what will happen tomorrow, never mind how much money you will need in 10, 20, 30 or 40 years from now. Us humans love certainty, but focusing on a single number to accumulate decades into the future may not be the best approach.
I can’t tell you the exact percentage of savings that will lead to financial independence or a riskless retirement. What I can tell you is that general rules of thumb and static financial plans will not get you to where you want to be. I can also walk you through how to think about determining your savings rate and when adjustments should be made to get the probabilities of success on your side.
Good financial planning incorporates the reality of external (uncontrollable) events and life changes into a plan, and uses analysis and projections as goal posts that are revisited and altered when necessary. That’s why I prefer a safe savings rate approach that changes as your lifestyle and income does. The original plan can and often does change substantially as your life progresses. The safe savings rate approach incorporates change into the initial plan and is revisited frequently to determine if the initial targets still makes sense.
The process I work though consists of two steps, and can provide a framework for how to model out your ever changing savings needs.
Step One: How much income are you looking to replace?
Step one involves grabbing your crystal ball and determining how much of your retirement spending will be financed with your savings. In addition to estimating your spending decades into the future, you’ll also want to accurately estimate your income from Social Security and any other pensions you might have. Easy!
Replacement rates will certainly vary from person to person, but in most instances you can estimate that you will need to replace less than 100% of your pre-retirement expenses. Spending does tend to decline with age, taxes are (hopefully) less, and you no longer have to… save for retirement. When you look at it from this sense, high earners will typically see the most dramatic spending declines as they enter retirement (their taxes are higher and their savings need to be higher). Additionally, Social Security is a progressive system, where those with lower incomes will have a greater percentage of their spending covered than those with higher incomes. Academic research has shown that a 40% replacement rate for high earners is a conservative estimate.
Step Two: Calculate Your Savings Rate
Once you’ve determined your replacement rate you can grab your crystal ball again and determine your unique income path, forecasted portfolio returns and future assumed withdrawal rates. Should be spot on.
All jokes aside, you can use the assumptions to run your projections. What percentage of your income needs to be saved to become financially independent at your target age? The savings rate and planning software can help you understand the tradeoffs necessary to reach financial independence at different ages, and help you reverse budget to determine if the lifestyle changes necessary to fund your savings align with your expectations.
Three things will become abundantly clear as you tinker with different savings rates, time frames and market returns.
1. Securing a higher probability of success is extremely costly
Aiming for a 95% rate of success over a 90% rate of success can add up to a couple of additional percentage points per year of saving. Better safe than sorry? Maybe not when being overly prudent can seriously impact your standard of living. What are you willing to forego in order for the additional safety of a higher savings rate? Is it necessary?
2. Starting early really, really matters
Beginning your savings plan as early as possible leads to better outcomes. That much isn’t up for debate. Delaying saving for five to ten years can severely impact how much you need to stash away going forward. Even if you aren’t saving much early on, the power of compound interest can reap tremendous benefits over long periods of time. However, relatively low savings at the beginning of your career may not be enough to replace higher income needs as you near retirement. Key takeaway: begin saving early and consistently.
3. Your income path and adjustments matters
Another large unknown. Can you tell me how your income will progress for the next 30 years? Certainly not easy to do. However, defining your retirement or financial independence goal as a replacement rate helps to manage this uncertainty. As your income rises your target retirement income should increase as well, theoretically.
(Actual) Financial Planning and Flexibility
Studies have shown that those with higher income growth later in their careers tend to fail in meeting their income replacement goals at a higher rate. This shows the power of compound interest and the impact of saving early and often for retirement.
Not everyone can afford to save large percentages of their income early in their careers (coming out of school a few years the Great Recession was a blast). You need to spend on food, housing, car insurance, health insurance and everything else in between.
As you continue to progress in your life and career your income path becomes more obvious because, well, you don’t actually have to guess how much you’ll make when you’re 45 if you are 45. This leads to the only way to handle the ambiguity that comes with financial planning and saving for far off goals. Change your savings rate as your income changes. Genius, I know.
As your income increases over time, you’ll be able to direct more towards your savings. While you shouldn’t spurn saving entirely early in your career, increasing your savings rate during your peak earning years can still lead to a high probability of success in reaching your financial independence or retirement goals. Early retirements can take substantially higher savings rates and the tradeoffs should be weighed accordingly.
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