Are You Saving Enough for Retirement?

One of the most vexing and controversial questions in planning for a financially secure retirement has to do with how much to save during your working years to maintain your standard of living in retirement. Fortunately, most retirees can live just as well on less than they made while they were working. Various studies suggest income "replacement rates" (typically defined as a percentage of your final working year's salary that would be required to maintain your standard of living) in the 60% to 80% range, with some advisors suggesting full replacement.

However, even with recommendations of income replacement well shy of 100% of preretirement levels, many investors still struggle to save enough in their working years, risking an inadequate retirement nest egg. In fact, a study published by the Center for Retirement Research at Boston College argues that up to 43% of American households are at risk of falling short of what they'll need in retirement. There are many reasons for why investors fail, some within their control and others not. And while we've written about the crucial questions investors need to ask about their retirement savings, we'll focus here on one factor you can control--your actual savings rate.

Using Morningstar's Retirement Savings Calculator
On the Personal Finance page of Morningstar's Web site you'll find our Retirement Savings Calculator, which was introduced earlier this year and is based on the innovative research of Ibbotson Associates, a unit of Morningstar. The designers of this tool sought to improve on existing retirement savings rate estimates in two important ways. First, they calculated the income one would need in retirement based on a percentage of net-pre-retirement income. In other words, they take into account the fact that while in retirement investors no longer need to save for retirement and thus require a reduced amount of income. Second, when estimating the savings rate required, the researchers used dynamic Monte Carlo simulations and Ibbotson asset class return forecasts. These improvements can hopefully help account better for the range of possible investment outcomes one might experience.

When using the calculator, the tool's variables allow you to experiment with different scenarios and determine varying outcomes based on fresh inputs of your age, annual income, and how much you've already saved for retirement. Also, the calculator makes clear how important it is to begin saving early. In fact, Ibbotson research shows that "the recommended savings rate for a person starting to save at 25 typically more than doubles if they wait until age 45 to start saving, and triples if they wait until age 55." The research suggests that a "critical inflection point occurs at age 35 to 40," after which individuals may need to think about late-start retirement strategies to improve their financial picture. We think the tool is an excellent first step toward understanding your proper retirement savings rate, but you should use it only as a guide. In fact, you might find that other considerations argue for an even higher savings rate.

Differing Savings Rate Levels: The Arguments
Both the Ibbotson research (which used both 60% and 80% income-replacement scenarios) and that of the CRR (which used between 65% and 85% replacement, depending on income group and household type) argue that individuals require considerably less than their full preretirement income once in retirement, and both cite similar rationales. Not only do you not need to save for retirement in retirement, but it's also likely that you'll be finished paying for your kids' college educations, and that you'll pay less in federal income tax, as well as no Social Security taxes. You also don't have to worry about work-related expenses.

While all these arguments make good sense and are compelling to a point, we think there are other considerations that need to be taken into account when determining your proper savings rate. For instance, neither study adequately addresses the significant issue of retirement-age medical costs, a substantial and rapidly growing expense for retirees. In fact, as my colleague Sue Stevens recently argued in a piece on risks in retirement years, "The Employee Benefit Research Institute estimates that a couple (with both spouses age 65) could require as much as $295,000 to cover health insurance premiums and out-of-pocket expenses if they live to their life expectancy. If they live to age 95, that number jumps to $550,000." This could easily make retirement-age medical costs the second- or third-largest lifetime expense, next to housing and college education in scope.

Likewise, while retirement ages may differ for future generations, the Ibbotson study assumes a retirement age of 65 (the age at which individuals become eligible for Medicare), but as CRR research points out, actual retirement age is currently nearer 63 for men and 62 for women, suggesting an immediate expense for many households who need to purchase private health insurance to cover that gap. Finally, there are various more dramatic, yet hardly implausible, situations that suggest the importance of a higher savings rate, such as children or grandchildren requiring significant assistance, higher future tax rates on capital gains and dividends, a deteriorating Social Security or Medicare benefit, failure of a pension plan, or a long stretch of flat or declining market returns, among many other unforeseen eventualities.

Building a Margin of Safety into your Savings Rate
Given the many uncertainties in life, we'd suggest using our calculator as a base to build upon when you're determining your personal retirement savings rate, but make sure you account for your own risk tolerance and other factors, such as longevity, as well. Similar to the way you should look for a healthy margin of safety when evaluating the appropriate price to pay for a stock, consider building a personalized margin of safety into your retirement savings rate. This is one of those cases in which it's better to be safe than sorry. Saving more than you need isn't a problem, as knowing you'll have more later on won't be as much trouble as not having enough.