Photo courtesy of Amazing Travel Photos
In a previous article, I wrote about critical mass. (See Critical Mass in Retirement.) How long does it take to reach critical mass and how much should you be saving each year?
Meet Sam the Saver
To answer these questions, let’s assume a hypothetical investor. We’ll call him Sam the Saver. Sam is twenty years old and plans to work for 40 years until he retires at age 60. Then Sam will live off his retirement nest egg for the next 40 years until he is 100 at which point his money runs out and Sam expires. (How convenient! I said it was hypothetical.)
We are assuming that Sam is willing to deplete his nest egg and has no plans to leave a large estate to his heirs.
To keep things simple, suppose Sam earns 100 units per year. The units could use anything dollars, Euros, thousand dollars units, or one-ounce gold coins. Let’s say dollars. Sam saves X dollars and spends the rest, 100 - X, to pay for current consumption.
Sam’s Saving Rate
The one thing that Sam has a lot of control over is his savings rate. So how much should Sam save each year? The answer depends on the rate of return he will get from investing. To keep it simple, let’s assume he gets the same return every year both before and after retirement. We’ll do all the calculations after inflation, or in real dollars.
If Sam spends 50 dollars and saves 50 dollars each year, then every year he is saving enough for one year of retirement. After 40 years he has stashed away 2000 dollars, enough for 40 years of retirement spending 50 dollars per year. Sam can do this without any investment return above inflation. In other words, as long as his nest egg keeps pace with inflation, Sam will have enough.
(Again, if Sam earning $100 per year is not realistic enough for you, think of it as $100,000 per year. Sam saves $50,000 each year and stashed away $2 million after 40 years.)
If Sam spends 75 dollars and saves 25 dollars, then it takes three years to save enough for one year of spending. Now he needs some investment return above inflation to accumulate enough after 40 years of working for to pay for 40 year retirement. I set up an Excel spreadsheet to calculate this. It turns out, with an investment return of 2.78% real, or after inflation, he will have a nest egg of $1796 which will last 40 years spending 75 dollars per year.
Table 1 shows the investment return needed and the size of Sam’s nest egg for various savings rates. Notice that with higher consumption and lower savings rates, the return needed is larger. The less Sam is willing to save, the higher return he needs to make up for it.
| Consumption | Saving | Return Needed | Ultimate Size of Nest Egg |
|---|---|---|---|
| 50 | 50 | 0 | 2000 |
| 60 | 40 | 1.02% | 1963 |
| 70 | 30 | 2.14% | 1868 |
| 75 | 25 | 2.78% | 1796 |
| 80 | 20 | 3.53% | 1701 |
| 85 | 15 | 4.43% | 1579 |
| 90 | 10 | 5.65% | 1418 |
| 95 | 5 | 7.64% | 1178 |
| 98 | 2 | 10.22% | 939 |
Expected Returns
What kind of return is reasonable to expect from investing? Historically, stocks have returned about 7% after inflation and bonds have returned about 2% after inflation. A 50/50 mix has returned about 4.5% real after inflation. The widely recommended 60/40 returned about 5% real. Even with 100% stocks, it is not reasonable to expect more than a 7% real return.
But many expert are forecasting returns from stocks to be in the range of only 3% to 5% after inflation. So a portfolio that holds a mix of stocks and bonds may only return 2 to 4 percent real. From the table, this looks like Sam had better be saving 20% or more of his income to accumulate enough to retire.
Consume Less and Save More
The conclusion to draw us that you will need a high saving rate to accumulate enough to retire. You should be saving at least 20%. Probably more. If you saved 30% and invested only in safe inflation-protected Treasury bonds yielding at least 2.14%, everything would work out nicely. If you can save 40 or 50 percent, then retirement is pretty more a slam dunk.
The truth is, nobody knows what kind of returns we’ll get over the next 40 years. So the prudent thing to do is expect low returns and save more. The only way to do this is to spend and consume less. Then hope for decent returns, but if they don’t materialize, you will still be in good shape.
There are other reasons to have a higher savings rate that I don’t want to get into at this time, but I will mention briefly. One has to do with the volatility of returns which means that you don’t get the same return each year as I assumed in Table 1. In fact, some years there are losses.
Another reason is to reach critical mass sooner. This be become necessary if your company forces you into early retirement.
The views expressed in this article are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors, staff or any other organization.
