How much should you save for retirement?
I received a question from one of the subscribers this week – “How much should I save for retirement in order to maintain the same standard of living as I have now?” I did modify the original question slightly to generalize it to the broader audience. First, I want to thank you for asking the question.
Do you know that most Americans don’t know the answer to this question. What is even more scary is that not many have ever given considerable thought about it.
This is a fully loaded one and I will try my best to answer without trying to boil the ocean. What I have below is a lot assumptions and one approach to arrive at a nest egg. You can change a few variables, analyze, and determine your personal retirement nest egg needed by going through this post.
Time Value of Money
There are some basic pre-requisites we need to cover before I answer your question. You first need to understand the Time Value of Money. Once you grasp the time value of money, here is a post that you could read that would reinforce your learning – Sally Has A Retirement Question.
How much should you save for retirement
Here are my set of assumptions while we go about with the calculation:
- At retirement, your home is fully paid off. I don’t believe in carrying a mortgage into retirement.
- At retirement, your kids are done with college and are leading independent fiscally responsible lives.
- Your retirement (401k) grows at the rate of 8%.
- All compounding in this analysis is done on a monthly basis.
- Your age now is 30.
- You desired retirement age is 60.
- You have $0 in your 401k now.
- Your annual salary now is $75,000.
- Inflation has been ignored as it will vary over time.
- Also, salary is typically expected to increase by ~3% per year over the 30 year period which means this empowers you to save more. This has been ignored as well to keep things simple.
- You need 80% of your current salary to maintain the same standard of living you have now.
- 80% of $75,000 is $60,000.
Life Expectancy and Cash Flow at Retirement
Here is another set of assumptions on life expectancy and cash flow during retirement:
- You expect to live up to 85.
- You need $60,000 per year for 25 years right after age 60.
- Market Interest Rate is 4%. If not, you will need to invest your nest egg in bonds and manage the associated risks. How you manage your nest egg at retirement is outside the scope of this post.
- You are going to withdraw $5000 on a monthly basis ($5000 * 12 = $60,000)
- To calculate the required nest egg, in Excel, we need to calculate the present value of future $60,000 per year cash flows over the 25 year period – “=PV(0.04/12, 12*25, -5000)”
- The nest egg need = $947,262.
Retirement Monthly Savings
Now that we have determined you need a nest of $947,262, let us look into how much you need to set aside on a monthly basis to reach a nest egg of $947,262?
- Your retirement account grows at the rate of 8% per year.
- Compounding is done on a monthly basis.
- Your initial balance at age 30 (PV) is $0.
- Your needed balance at age 60 (FV) is $947,262.
- With this information you can calculate the monthly contribution you need to make towards your 401K by calculating for PMT.
- In Excel, type “=PMT(0.08/12, 12*30, 0, 947262)”.
- You need to invest $635.59 per month into your 401k.
- This translates to $7,627 per year or ~10.17% of your annual salary of $75,000.
Your situation may or may not match the above scenario. However, you know the assumptions, how to draw a timeline, and how to use Excel. I encourage you to analyze your personal situation and draw your own conclusions. And of course, I would love to hear your feedback.