The Short Answer

Take the Guesswork Out of Retirement Savings

Peng Chen, Ph.D., CFA, and Roger Ibbotson, Ph.D.

Determining your savings rate can feel like guesswork--how large might my nest egg grow in 20, 30, or 40 years, and is that enough? General rules of thumb for retirement saving aren't much help. They tend to overestimate how much you'll need in retirement, and they don't take into account how much you've already saved. But setting a savings rate for retirement doesn't have to be daunting. And those who start putting money away relatively early can save without a significant drop in lifestyle.

To determine your savings rate, you need to answer three basic questions (below) and may use the Retirement Savings Calculator on Morningstar's Personal Finance page to do the number-crunching for you.

1. How much will you need to live on each year in retirement?
Well, perhaps not as much as most people think, according to a recent study by Ibbotson Associates (a subsidiary of Morningstar) and Kreitler Associates that was published in the April issue of the Journal of Financial Planning. (I was one of the study's authors.) The standard answer is about 80% of your gross preretirement income. So if you were earning $100,000 when you retired at age 65, you would need $80,000 per year for the rest of your life. But what if you were saving 10% per year for retirement? That means you were living on only $90,000, so we would argue that a more accurate estimate of what you might require in retirement is 80% of net preretirement income--in this case 80% of $90,000.

Remember that you also won't need to replace the whole 80% of that net preretirement income yourself. Social Security will pay for a portion, so your goal is to fund the gap. And that gap will be significantly wider for individuals in higher income brackets. That's not just because they earn more and therefore have more income to replace in retirement. It's also because Social Security is capped at certain income levels. So people who earn more will have to save a greater percentage of their income than people who earn less, since Social Security funds a disproportionately smaller amount of their retirement income.

2. How much do you need to accumulate to finance this standard of living in retirement?
In the study, we assumed that the ending wealth value needed to fund retirement is the amount of money it would take to buy an inflation-indexed lifetime fixed-payout annuity that would provide a guaranteed payment equal to the gap between Social Security payments and 80% of net preretirement income. This is not to suggest that investors should put all of their savings in an immediate annuity at retirement, but the annuity formula is a reasonable and conservative way to estimate how much income the savings can sustain on an inflation-adjusted basis through retirement.

To purchase one of these annuities, 65-year-olds with varying incomes (the top line in the table below) would need the corresponding savings (bottom line) to fill the gap after Social Security payments in order to fund 80% of net preretirement income:

Income ($) 20,000 40,000 60,000 80,000 100,000 120,000
Required Savings ($) 68,650 194,775 349,637 523,658 702,467 919,594

3. So what savings rate will get you there?
You can use the Retirement Savings Calculator to get an approximate savings rate. This calculator assumes that individuals invest their savings to match the asset allocation of a typical age-appropriate target maturity fund and that their income increases with inflation over time. You can further customize the savings rate guideline for company contributions to 401(k) plans. Simply reduce the savings rate by the company contribution. For example, a 35-year-old earning $40,000 who has $50,000 saved needs to save 7.9%. But if he gets a company match of 3%, he needs to save only 4.9%.

With so many variables, it's important to check your progress over time. Because the markets, governmental health and retirement programs, and individuals' personal circumstances are ever-changing, these savings guidelines should be considered just that--guidelines. Individuals should monitor their savings against the table below and check back periodically with the calculator to adjust their savings rate to ensure they're on track to reach their retirement goals. This table benchmarks approximately how much individuals with various income levels should have accumulated over time to have a 90% probability of success.

 Savings Progress Checker ($)
  Inc ome    
Age 20,000 40,000 60,000 80,000 100,000 120,000
40 7,962 21,824 39,176 58,674 78,710 103,038
45 16,005 45,408 81,512 122,082 163,768 214,387
50 26,023 73,831 132,533 198,497 266,277 348,581
55 37,434 106,207 190,650 285,540 383,042 501,436
60 51,562 146,292 262,607 393,310 527,612 690,691
65 68,650 194,775 349,637 523,658 702,467 919,594

This article and theRetirement Savings Calculatorwere based on the study "National Savings Rate Guidelines for Individuals" by Roger Ibbotson, Ph.D, Peng Chen, Ph.D., CFA, and James Xiong, Ph.D., CFA, of Ibbotson Associates, a subsidiary of Morningstar Inc. and Robert P. Kreitler, CFP, and Charles F. Kreitler of Kreitler Associates. The study was originally published in the April 2007 issue of the Journal of Financial Planning.