A reader writes in asking:
“I’m 26, and I recently enrolled in my company’s 401k. I know to contribute at least enough to get the maximum match. But how much should I contribute to be on track to retire comfortably? I’ve read numbers anywhere from 10% on up.”
This is one of the most frustrating questions I ever receive. It’s frequently asked, and it’s super important, but I don’t have a very good answer.
The reason the question is so difficult to answer is that it spans such a lengthy period of time. It’s like the already-difficult-to-answer “how much money do I need to retire?” question, but with an additional 3-4 decades of uncertainty tacked on at the beginning of the analysis.
Safe Savings Rates
The best research I’ve seen on the topic is Wade Pfau’s study of “safe savings rates.” Pfau analyzed U.S. historical data (starting in 1926) to determine what percentage of salary an investor had to save per year in order to meet a certain income goal in even the worst-case historical scenario.
For example, Pfau found that for an investor who:
- Uses a fixed 60% stock, 40% bond allocation,
- Has 40 years to save,
- Expects retirement to last 30 years, and
- Wants to replace 70% of his/her pre-retirement income,
…a 12.27% savings rate would have gotten the job done in each historical scenario. (Table 1 of the article I linked to above shows the “safe savings rate” for various sets of inputs.)
Applying This Concept to Real Life
Unfortunately, applying this “safe savings rate” concept to your real-life finances is a bit tricky.
One complicating factor is the fact that safe savings rates are simultaneously:
- Probably higher than necessary (because in all historical U.S. outcomes except one, they resulted in excess savings), and
- Potentially not high enough (because the historical worst-case scenario is not in fact the worst-case scenario).
This is not a fault of Pfau’s work in any way. It’s simply the nature of using historical data to answer questions about the future. But how does one deal with such uncertainty? Should you adjust your savings rate upward (relative to the historical safe savings rate) just to be on the safe(r) side? Or should you plan for a more historically-normal scenario and adjust your savings rate downward?
In addition, we must remember that Pfau’s calculations involved a number of simplifying assumptions.
For example, he assumed that the investor’s inflation-adjusted income is constant throughout his/her working years. In real life, there are raises, promotions, layoffs, career changes, etc. For most people, the constant-real-income assumption is a conservative one — most people’s inflation-adjusted income increases over time. But it’s certainly possible that a particular investor could have the opposite experience. So, how should you adjust the “safe savings rate” to apply it to your own life? Again, there’s no easy answer.
And the calculations ignore taxes completely too. In real life, taxes will play a role in determining:
- The net rate of return that your investments earn (if you’re investing in a taxable account), and
- The amount that you’ll have to withdraw from the portfolio per year in order to have a given level of after-tax income.
Of course, it’s difficult to predict with any meaningful degree of certainty how your personal tax rate will change over the next 6-7 decades.
Pfau’s research is helpful in that it gives us something to work with. But once we account for all the different types of uncertainty involved (e.g., investment returns, tax rates, changes in your income over the course of your career, changes in Social Security, the age at which you’ll retire, and the age at which you’ll die) it’s simply not possible to get any more than a very rough idea of how much a young person should be saving for retirement each year.
While I admit it sounds like a total cop-out, I think the most honest answer I can give to somebody early in her career is, “save what you can (hopefully 10% or more), and make sure to reassess the situation every few years.”