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 won’t know the percentage you need to save, if you don’t 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.

1.        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 short-term, since it will be spent within a 12-month period.  When you are preparing your annual budget, this money should be shown under the applicable expense categories, rather than as savings.

2.       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.  Generally, the greater the family’s medical, disability, and property insurance coverage, the lower the amount that needs to be kept in emergency savings.  [Note: 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 a real emergency does arise.]  

3.         Savings for anticipated major expenditures that don’t 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 the major long-term financial goals for your family, with the exception of retirement, which will be considered when we discuss the next category of savings.  These 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. To determine how much you will need to save each year to have a sufficient amount to pay for each specific expenditure as it arises, simply determine the total amount that you will need for that expenditure and divide it by the number of years remaining before you expect to make the expenditure.   

To illustrate: 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 for the replacement car.  You will need to make similar calculations for each item on your list.

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

·       Purchase of your first house or a larger house than the one in which you are now living

·       Get completely out of debt -- perhaps even including the mortgage on your house

·       Replace your 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 for each year they attend.  (Of course, you don’t have to pay all of their college expenses.)

4.       Savings to supplement other sources of retirement income.  Supplemental sources of savings include IRAs, 401(k)s, etc.  To determine how much you will need to save to supplement your other sources of retirement income, be sure to include each of the following steps:

·       You and your spouse will need to decide when or if each of you plans to retire, keeping in mind that in today’s world, people are often forced to retire from their regular job sooner than they would prefer.  

·       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.   (Do likewise if you are entitled to deferred compensation from any of the companies.)  It probably would be helpful to you to know what the benefit would be if the company’s calculations were made using several different assumptions as to your retirement age (e.g., 55, 60, 62, 65).  [Note: The total dollar amount of company plans that don’t 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.”]

·      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.

·       Determine 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. 

·   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 won’t increase, regardless of how long you live, and increases in Social Security benefits alone won’t provide adequate protection from the ravages of inflation.  

·       Determine how much total retirement savings you are likely to need to provide you with the necessary annual supplemental income.  To do this, you will first need to decide how aggressively you will be investing the money that you save for retirement.  If you are comfortable with a higher degree of risk, you should be able to earn a higher return on your investments over a long period of time (10 years or more) and, therefore, you are not apt to need to save as much as if you invested more conservatively.

For most people, it would be prudent to have a mixture of stocks and interest income investments.  However, there is no simple 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.

 

               APPENDIX A

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.

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. 

For example, you could decide to 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 year since then.

Thus, if your retirement savings at the end of the third year of your retirement had declined 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 had been 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 they retire 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).