Longtime Oblivious Investor reader Larry recently pointed me to an article from Kiplinger in which the author suggests that people save 10.6-times their annual salary before retiring.
Statements like that drive me crazy.
It makes no sense to make retirement savings suggestions in terms of years of income. Rather, we need to measure in terms of spending.
For example, consider two investors, both starting to approach retirement age:
- Investor A has a $65,000 annual income, and he is saving $5,000 per year.
- Investor B has a $65,000 annual income, and she is saving $15,000 per year.
In order to retire without a change in living standard, Investor A needs to fund $60,000 in annual spending, while Investor B only needs to fund $50,000. (We’re ignoring taxes for the moment.) In other words, Investor A will need 20% more money saved than Investor B, even though their incomes are the same.
The suggestion that the two investors should each save the same amount of money (10.6-times their annual income) either understates A’s need for savings, overstates B’s need for savings, or both.
The Best (More Time-Consuming) Approach
The best approach to projecting your retirement spending is to go through your last year of bank statements, credit card statements, and pay stubs, tallying up your current spending in each budget category (food, medical, housing, etc.). From there, you can do your best to estimate how each spending category will change as you move into (and through) retirement.
The Quick and Dirty Approach
I know from experience, however, that many people don’t want to take the time to do the above analysis. In that case, I’d suggest at least doing the following calculation:
- How much did you earn last year (net of taxes)?
- Subtract the amount you saved over the course of the year. (Not the change in your account values, just the amount you actually put into those accounts.)
- Subtract the amount of debt you paid off.
- Add the amount of new debt that you took on.
The total is how much money you spent over the last year. Again, from there, you should do your best to estimate how each category of spending will change as you move into (and through) retirement. (Naturally, this is somewhat less precise than it would be if you had the category-by-category spending totals provided by the more thorough method described above.)
Then, once you know how much you expect to spend each year in retirement, you can start the process of determining how much money you need saved for retirement.