Sufficient Savings

The critical consideration in determining how much to save is the total dollar amount that you are likely to need, rather than the percentage of your annual earnings that you ought to save.  You will not know the percentage you need to save, if you do not know the amount you need to save.  To determine the total dollar amount to save, you will need to look at each of the four basic types of savings.

A.  Temporary savings for large, recurring expenses that are not payable every month, but which occur at least annually, such as real estate taxes and vacation expenses.  A Christmas savings account would also be included this category of savings.  Unlike the other three types of savings, which are long-term in nature, this type of savings is relatively short-term, since the money generally will be spent within a 12-month period.

When you are recording your monthly expenses on your budget, money that you are saving for real estate taxes, vacations, etc. can be shown in a category entitled “Temporary Savings.” Subsequently, when money is spent to pay the real estate taxes, vacations, etc., it should be shown as an expense and an equal amount should be subtracted from “Temporary Savings.”

If the actual amounts of these types of expenditures for the entire year are less than the total amount you previously placed in “Temporary Savings,” you can add the unspent amount to one or more of your other savings categories or leave it in Temporary Savings for your spending during the next 12 months..  On the other hand, if the actual amounts of these types of expenditures for the entire year are more than the total amount you have placed in  “Temporary Savings,” the extra amount you have spent will need to be subtracted from one or more of your other categories of savings.

B.  Savings for emergencies such as temporary unemployment by you or your spouse, or to pay for unreimbursed costs of a major accident or illness involving a member of your family.  Most experts recommend that the amount of a family’s emergency savings equal two months to six months of the primary wage earner’s after-tax income.  However, there are ample reasons to set a minimum of six months of after-tax income.

Generally, the greater your family’s medical, disability, and property insurance coverage, the lower the amount that you need to keep in emergency savings.  Although you may be tempted to use emergency savings for other purposes, they should be used only for genuine emergencies, because if they are used otherwise, you may not have sufficient money available to use when you experience a real emergency.

C.  Savings for anticipated major expenditures that do not occur every year.  Determining how much you will need to save for such expenditures will require you and your spouse to write down all of  your expected major long-term spending needs and goals for your family, with the exception of retirement, which will be considered in the next category of savings that we will discuss.

To the extent that it is feasible, your expected major long-term spending needs and goals should include both a reasonable estimate of the amount of money that will be required and an approximate date as to when you expect to need the money. In determining how much you will need to save each year to pay for these expenditures as they arise, simply determine the total amount that you will need for each such expenditure and divide that amount by the number of years remaining before you expect to make the expenditure.

Example: If you plan to purchase a replacement car in about three years at a cost of roughly $15,000 and you expect to sell or trade-in your current car at that time for approximately $3,000, you will need to save an average of about $4,000 a year during the next three years, assuming that you would prefer to pay cash, rather than borrow any money, for the replacement car.  Likewise, it would be prudent for you to make similar calculations for each item on your list of future major expenditures.

In addition to replacing your current car(s), your major long-term financial goals may include the following:

• Purchase your first house or a larger house than the one in which you are now living
• Get completely out of debt – perhaps, including the mortgage on your house
• Replace your heating and/or air conditioning systems when necessary
• Replace your future car(s) on a timely basis
• Replace your appliances as necessary
• Purchase new furniture
• Take one or more especially nice vacations
• Finance the expenses of your children’s college educations. (However, you do not need to save enough to pay for all of their college expenses.)

D.  Savings to supplement other sources of retirement income. Supplemental sources of savings include IRAs, 401(k)s, etc.

An article in The Wall Street Journal (3-21-10) asked, “Just how much are you going to need in order to retire comfortably?” The article then stated, “It may be the biggest financial question in your life.” The article went on to say,

[A] horrifying number of people have never even asked [this question] and may not know how to find answers.

One of the biggest reasons people haven’t saved enough for retirement is that they don’t realize how much they will need.

In this regard, another Wall Street Journal article (7-3-05) stated, “Not knowing the target you’re aiming for is like being handed a gun and told to shoot for the bull’s eye – blindfolded.”

Therefore, it is important to make a reasonable estimate of how much you are likely to need to save to supplement your other sources of retirement income.  Be sure that the following steps are included:

1. You and your spouse need to decide when – or if – each of you plans to retire, keeping in mind that there are a number of circumstance that can cause people to retire from their regular job sooner than they would prefer.

2. Prepare a budget of your expenses that assumes that both you and your spouse are retired. If you are already budgeting your annual spending, probably only a few adjustments will be necessary.  Otherwise, you will need to prepare a complete budget from scratch, based upon your current situation and then make the necessary adjustments. Without a budget, it would be much more difficult to determine how much income you will need when you retire.

Your retirement budget should reflect all expected changes in your expenses.  For example, after you retire, your cost of eating out at lunchtime may drop to zero, but your grocery bill is likely to increase somewhat, since you probably will be eating lunch at home more often.  In addition, your clothing expenses are apt to decline, but you can expect your medical expenses to rise.  Likewise, other expense categories may increase or decrease significantly after you retire.

3. If you or your spouse have worked for any companies that have a pension plan, request those companies to provide you with the annual amount of your pension benefit under different retirement age assumptions (e.g., 55, 60, 62, 65). Do likewise if you are entitled to deferred compensation from any of the companies for which you worked.  [Note: The total dollar amount of company plans that do not have a defined benefit (e.g., a 401(k) plan) should not be included in this step, but should be included as part of your total retirement savings, which we will discuss in step 7.]

4. Determine your Social Security benefits. The Social Security Administration is supposed to send you information annually as to the amount of your retirement benefit you will receive.  Three retirement benefits figures are shown — one for each of the following assumptions:  (1) early benefits at age 62, (2) normal benefits at age 65 or older, depending on when you were born, or (3) late benefits at age 70.  If you do not receive this information, send a request form to the Social Security Administration.

5. Decide how much additional (i.e., supplemental) annual income, if any, you will need when you retire. To do this, determine the total of your annual Social Security benefits plus your annual pension benefits, if any, from each company for which you have worked. Then subtract from this total the amount of your estimated annual expenses that you calculated in step 2.

6. Take inflation into consideration when you are deciding how much total retirement savings you will need. Otherwise, what may be ample retirement income when you retire will become increasingly inadequate over a period of years.  For example, with only 4% annual inflation, every $10,000 that you spend in the first year that you retire will increase steadily each year to almost $22,000 by the end of the 20th year after you retire – and keep on increasing in each subsequent year.  Keep in mind that, even if you receive pension benefits after you retire, these benefits generally will not increase, regardless of how long you live, and increases in Social Security benefits alone will not provide adequate protection from the ravages of inflation.

7. Decide how aggressively you will invest the money you save for retirement. If you are willing to accept higher degrees of risk, especially 15 or more years before you plan to retire, you may be able to earn higher returns on your investments and, therefore, you may not  need to save as much as if you invested more conservatively.

In this regard, an article in The Wall Street Journal (12-6-10) stated,

When your nest egg is small and time is short, you can make things worse for yourself by being either too conservative or too aggressive.

[W]hile stocks are typically the driving force in a long-term portfolio, due to their higher average returns over time, they are also a wild card. Pre-retirees face a catch-up conundrum: They could sure use the payoff from being heavily invested in stocks when the market is in a strong upswing. But they can’t afford the risk of having their already skimpy nest eggs decimated shortly before or after they leave the work force.

[I]f you’ve already got a lot in stocks, increasing that bet further could backfire – making your returns so unpredictable that it actually reduces the amount of money you can safely withdraw from your portfolio.

[P]eople within three to five years of retirement should have no more than 60% of their assets in stocks and preferably closer to 40%.

For most people, it would be prudent to have a mixture of stocks and interest income investments.  However, there is no formula to determine exactly what mix of stocks and interest income investments you will need to be certain that you will attain your savings goal. [To determine the probability of successful saving for retirement using several different mixes of stocks and bonds, see Appendix B.]

Although a number of sources, including various websites, may provide you with additional help in determining how much to save, most of these sources assume that a person’s investments will earn a constant investment return, which certainly is not true when you are investing in common stocks or mutual funds that own common stocks.  Among the web sites that seem to be the most helpful are the following:

• • analyzenow.com
  • fidelity.com
  • kiplinger.com

If you can’t save as much as indicated by the calculation of your own savings needs, you have three other options: (1) continue working until you do have enough saved, based on a shorter expected period of retirement, (2) reduce your living expenses sufficiently to allow you to retire with a lower amount of savings, or try a combination of both (1) and (2). And if your common stock investments perform very poorly during the early years of your retirement, you may find it necessary to get a part-time job for awhile, reduce your living expenses, or a combination of both.

Even if you are able to save as much as indicated by the calculation of your savings needs, you may want to give serious consideration to having guidelines to reduce the risk that your withdrawals will drastically deplete your retirement savings.  [Appendix A provides an example of how to do this.]

Appendix A

How to Reduce the Risk of Depleting Retirement Savings

Even if you are able to save as much as indicated by the calculation of your savings needs, you may want to give serious consideration to having guidelines to reduce the risk that your withdrawals will drastically deplete your retirement savings.

Assume:

· Your projected total retirement savings at the time you retire will be approximately $200,000.

· You expect to need $10,000 of supplemental annual pretax income in the first year after you retire. (This amount is 5% of your projected total retirement savings at the time you retire.)

· You hope to be able to earn an annual pretax rate of return of 8% on your retirement savings by investing in a combination of common stocks and interest income investments. Note, however, that an 8% average annual return on an investment portfolio with a substantial percentage of interest income investments is quite optimistic.

Problems:

· In any one year, or even for a period of several years, the actual annual returns on your retirement savings could be significantly less than you expect, perhaps because of a sharp decline in the prices of your common stocks and/or a substantial decline in interest income rates. You may even suffer a negative return (i.e., a loss) during some periods.

· Under such circumstances, if you continue to withdraw money from your retirement savings on the basis of your original assumptions, you will increase the risk that your withdrawals will drastically deplete your retirement savings.

So, what action should you take? Consider utilizing guideline limits for your withdrawals each year.

Such a guideline would restrict your annual withdrawals to the lesser of (a) a percentage of your retirement savings balance at the end of the prior year (e.g., 5%), or (b) the amount of supplemental annual income you needed in the first year after you retired, adjusted for inflation in each subsequent year.

Thus, if your retirement savings at the end of the third year of your retirement decline to $186,000 from the original $200,000, a withdrawal of 5% would amount to $9,300.

And, if inflation during the three-year period was 3.0%, 3.5%, and 4.5%, respectively, the amount you would need to maintain the purchasing power of the original $10,000 would be about $11,114 ($10,000 times [1.030 X 1.035 X 1.045]).

Using the guideline limits noted above, you would restrict your withdrawal in the fourth year to $9,300, rather than taking out the $11,114 needed to maintain the purchasing power of the original $10,000.

APPENDIX B

DETERMINING PROBABILITY OF SUCCESSFUL SAVING FOR RETIREMENT*

Source: T. Rowe Price Associates

*The percentages in the column under each of the portfolio mixes of stocks and bonds are based upon computer simulations that illustrate how often in the past the indicated withdrawal rate would have provided income throughout the entire retirement period that is shown. Although the past success rates of the various portfolio mixes can be a useful guide, future results may be better or worse than the results presented in this analysis.

The following is evident from the table above:

• The longer the number of years in retirement, the more difficult it would have been to save sufficiently, regardless of the mix of stocks and bonds.

• The higher the annual withdrawal rate, the more difficult it would have been to save sufficiently, regardless of the mix of stocks and bonds.

• Although it generally would have been better to have a higher proportion of stocks than bonds in a portfolio, there have been some exceptions, particularly when the annual withdrawal rate was limited to 4%.

Therefore, a person who expects to live for 30 years or longer after he/she retires needs to be very careful to avoid withdrawing more than 4% annually from their savings, especially if they plan to invest conservatively (i.e., have less than 60% of their savings invested in stocks).