Three Questions to Ask About Your Retirement Savings

Frustrated by the effort required to complete his tax return, the mildly troubled main character in Saul Bellow's Herzog writes, "Dear Mr. President, You're turning us into a nation of bookkeepers."

Unfortunately, with more of the burden of managing retirement savings falling squarely on our shoulders due to the uncertainty of Social Security and the phasing out of corporate pension plans in favor of 401(k) plans, we have to be more a nation of "bookkeepers" than ever these days. In fact, it may seem like we have to become full-blown financial planners in some ways, estimating what we'll need in retirement, saving the right amount along the way, managing our asset allocations, and peeling savings off of our accounts in an orderly fashion once we get there.

Saving for retirement doesn't have to be as daunting as it seems, however. You don't need to become a Certified Financial Planner to get your retirement plan in gear. Keeping your attention focused on three basic questions can take you a long way through the process.

1. How much income will I need in retirement to maintain my standard of living?
The fancy academic studies call this the question of the "replacement rate," or how much of your salary in your final working years you can replace in retirement. It is obviously the crucial question that everyone must face as retirement nears. A recent study by members of the Center for Retirement Research at Boston College estimates that all groups of retirees (single men, single women, and couples with one or two earners in all income ranges) would need to replace at least 65% of their income from their final working years in retirement in order to maintain their standard of living. Middle-income households tend to need a replacement rate of 70% to 75% instead of 100% mostly because only part of Social Security is taxed and because saving for retirement usually ends once a person enters retirement.

This study also discovered that using wealth-to-income patterns in the Federal Reserve's Survey of Consumer Finances (SCF) could help project the future financial situations of younger couples. This survey of 4,500 sample households has been conducted every three years since 1983. It questions households about their income, wealth, pension coverage, and a host of other financial matters. Each of the eight surveys since 1983 have produced a consistent picture, showing a median wealth-to-income ratio of about 1 (meaning that households with earnings of $40,000 would tend to have savings in that same ballpark) for 35-year-olds and a median wealth-to-income ratio of about 4 for those in their early 60s. (For the purposes of the survey, "wealth" does not include pensions or Social Security.) According to the study, this wealth-to-income ratio indicates that people aren't saving enough of their income to finance their retirements. Indeed, the study concludes that 43% of households are currently at risk of not replacing enough of their preretirement income with adequate retirement income.

These two statistics--wealth-to-income ratio of 4 and 75% of replacement income--don't directly answer the question of how much you're likely to earn in your last working years, thereby giving us a dollar amount for retirement income. However, they can help explain the difficulty that many retirees are confronting. Read on to see how.

2. How large a nest egg do I need for retirement?
Let's say a couple needs to replace $100,000 of income annually. Clearly, two Social Security checks won't cover that. If the couple doesn't have pensions, they better well have saved a lot in their 401(k) and other accounts to generate the roughly $75,000 (75% of their combined salaries) of replacement income they need. The current maximum benefit paid by Social Security is roughly $2,000 per month. Assuming our fictional retired couple is getting the maximum ($48,000 per year), they'd have to come up with another $27,000 to maintain their standard of living.

So, anticipating no pensions from their employers, what amount of capital could generate the amount of income they will need throughout a long retirement? (Incidentally, average life expectancy is 75 years for an American male and 80 for an American female, but if you're in good health and have a family history of longevity, running out of money could be a potential problem.)

There's actually no exact answer to this question, because different asset allocations (the percentages of stocks, bonds, and cash you maintain in your portfolio) will produce different results, and the financial markets are unpredictable. However, as my colleague Sue Stevens illustrated in the May 2005 issue of Morningstar Practical Finance, financial planners use "Monte Carlo" simulations (statistical approximations) to indicate how portfolios with different asset allocations would perform under different multiyear circumstances. The studies done with these simulations consisting of different allocations seem to indicate that a 4% to 5% annual withdrawal rate should keep principal intact for 40 years, while allowing retirees to keep up with an assumed inflation rate of 3%. A $600,000 lump sum at retirement, assuming a 4.5% withdrawal rate, should do the trick with most allocations for our hypothetical couple.

Going back to the average wealth-to-income ratio I mentioned earlier, our fictional couple would likely have saved only $400,000 (4 times their income of $100,000). This amount would be only two thirds of what they probably need. To make up for it, they would have to peel nearly 7% off of their savings every year, which would put them at risk for running out of money.

3. How much do I have to save to build that nest egg?
In other words, how can our couple accumulate the $600,000 that they need for income generation in retirement? If we use a financial calculator, we can see that if they save $3,482 per year for 35 years and achieve an 8% annual return, they can wind up with a bit more than $600,000. In this example, $3,482 is payment ("PMT"), 35 is years ("N"), 8 is the interest rate ("i%"), and $600,000 is the future value of our investments ("FV"). If you play around with the numbers, you can see that if they only have 15 years left until retirement, they need to save about $22,000 per year to get to $600,000, assuming the same rate of return. Clearly, starting a savings plan earlier can be much less painful.

Of course, planning your retirement is a complicated business with many moving parts, and there are many questions we haven't discussed, such as assessing your life expectancy and what your asset allocation should be at different stages in your life. For example, generating the 8% rate of return that we just assumed in the accumulation or savings phase of your life won't happen by keeping your money in a simple bank account. However, if you keep these three questions in your mind--how much income you'll need to generate in retirement, how much capital will safely generate the amount of income you need, and how much you have to save to build that pile of capital--you'll help yourself enormously.

Finally, don't be afraid to ask for help by going to a financial planner. My colleague Christine Benz has provided some helpful guidelines for seeking one out. Armed with these three questions, you'll be in a good position to evaluate and benefit from your planner's advice. Also, we encourage you to peruse Sue Stevens' series of excellent articles on retirement in the Morningstar.com Retirement Center.