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Saving Rates for Retirement

By Marc Amateis

Clients often ask me how much they can safely withdraw from their investment portfolio in retirement and not run out of money.  This is a very important question, and our firm is comfortable recommending a 4% to 5% annual withdrawal rate

But this begs another question for younger workers: “What should my retirement savings rate be during my working years?”  A study published in the Journal of Financial Planning addresses this question.

The study’s author, Wade D. Pfau, is an associate professor of economics at the National Graduate Institute for Policy Studies, in Tokyo. He starts with the assumption of a worker targeting a retirement income from savings of 50% of their final salary, with Social Security providing additional income. For example, someone earning $80,000 just before retirement would be aiming for income from retirement savings of $40,000 a year. 

During the savings phase, Prof. Pfau assumes an investment mix of 60% stocks and 40% bonds.  The study then looked at market data from 1871 to 2009 to see how such a scenario played out.  

Using the assumptions above, a worker saving for 30 years would have needed to put away 16.6% of annual income in order to always have a big enough pot of money for retirement.  Someone who saved for 40 years had to set aside only 8.8% annually to always meet the retirement goal (another reminder that it pays to start saving early). 

Learn more:
  • Please click here to read “Saving for Retirement” from the Financial Industry Regulatory Authority.
  • Research suggests that Americans improve their retirement outlook just by considering how much they’ll need to save. Brian Kilb offers a simple way to arrive at “The Number.” Read more.

To really understand the value of thinking about a proper savings rate as well as a proper withdrawal rate, consider the following paradox:  Two individuals have each accumulated $1 million at the start of 2008. The first person retires and using 4% as a guideline withdraws an inflation-adjusted $40,000 a year throughout retirement.

In 2008, both individuals experience a decline in their portfolios to $700,000. The second person retires in 2009, but the same 4% rule means an inflation-adjusted withdrawal amount of only $28,000 a year throughout retirement.   

In order to address this dilemma, Dr. Pfau suggests that younger workers focus on a “safe savings rate” that would allow both individuals to withdraw the same 50% of final salary annually. 

The reason that a “safe savings rate” is so important is that it does not depend on the valuation of the stock market at one’s retirement date, while the withdrawal rate does.  People who retire at market peaks will see their nest egg eroded by subsequent bear markets and may not be able to sustain the withdrawal rate.  On the other hand, people who retire at market bottoms may be needlessly frugal as the subsequent bull market outpaces their withdrawals.

For those who no longer have 30 or 40 years to save for retirement, our firm is still comfortable with an annual withdrawal rate of 4% or 5% from accumulated savings. But for those with more time before retirement, by starting early with a proper savings plan, the question of how much to reasonably withdraw in retirement will largely be answered.

Marc Amateis is vice president at Landaas & Company.

initially posted Jan. 6, 2012

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