Many workers today will probably need a seven-figure nest egg to cover their full retirement costs. Saving that is a daunting task, and it's made more difficult by the fact that we can't predict exactly how much we'll need or how quickly our investments will grow.
Most people default to saving a certain percentage of their income and hoping for the best. A recent Transamerica survey found that the median savings rate among full- and part-time workers was 12% of their monthly income. But is that really enough? Here's how to answer that question for yourself.
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Everyone's situation is different
Saving 12% of your income means different things to different people. If you earn $100,000 per year, 12% amounts to $12,000. But if you only make $30,000 per year, 12% is $3,600. Obviously, in the former scenario, you're going to be able to build a substantial nest egg more quickly, and possibly retire sooner.
The appropriate savings rate for you also depends on the kind of lifestyle you want to have in retirement. Someone who plans to travel the world and purchase a vacation home, for example, will need a lot more money than someone who plans to stay in a home that they've already paid off.
Saving 12% of your paychecks is a great start, and it's definitely better than not saving at all or making infrequent contributions. But if you're just diverting money into your 401(k) or IRA without a second thought, you might not be doing enough.
Plan for your actual retirement expenses
To get an accurate estimate of how much you need to save for retirement, you need to consider what your life will be like then. Start by thinking about the type of lifestyle you plan to have in retirement, including where you're going to live, how you want to spend your time, and how your monthly expenses will change between now and then. Also note any other sources of income you may be able to rely on in retirement.
Most people will be able to count on Social Security, and some others may get a pension as well. Talk to your employer about estimating the value of your pension and create a my Social Security account to get an idea of how big your benefit will be. Estimate how much you'll get from these sources in a year, and then subtract this from your annual retirement costs to figure out how much of your yearly expenses you'll be responsible for on your own.
Next, estimate how many years you plan to spend in retirement. Think about when you'd like to leave the workforce and how long you expect to live. Don't be afraid to be a little optimistic here. It's better to save for a longer retirement and not use your whole nest egg than to run out of savings prematurely.
And don't forget about inflation, which will drive up the cost of everything over time. The typical rule of thumb is to assume a 3% annual inflation rate. In some years, like 2022, it might be higher than this, but in other years it may be lower. If you want to be extra safe, you could plan for a slightly higher inflation rate.
Once you have all the above information, you should be able to estimate how much your retirement will cost you. Multiply your annual retirement expenses not covered by Social Security or other sources of income by the number of years of your retirement and add 3% annually for inflation. This should give you a rough guess at how much you need -- but again, you won't have to save it all alone.
Your investments will accrue earnings over time, and the more earnings you have, the less you need to set aside for retirement. It's best to plan for a 5% or 6% annual rate of return to be conservative, though your money may grow more quickly than this.
Use a retirement calculator to estimate how much you need to save per month in order to reach your savings target. If you're getting a 401(k) match from an employer, subtract this from your monthly savings target to figure out how much you must save on your own.
The result could end up being more or less than 12% of your income. Whenever possible, aim to save the amount you've calculated rather than an arbitrary percentage.
If you're not able to save as much as you'd like, set aside as much as you can and try to increase your contribution amount by 1% of your income per year. You could also rethink your retirement timeline. Delaying retirement gives you additional time to save, and it also allows your investments to grow for longer before you need to withdraw them.
Once you have a plan in place, do your best to adhere to it. But be willing to adjust if your circumstances change. Schedule an annual retirement plan review where you revisit all the information discussed here and update your savings strategy as appropriate.
