A prominent debate in the financial advisor industry examines what is a safe withdrawal rate from a retired person’s investment portfolio. It’s not quite consensus, but it is generally considered that you can withdraw 4% of the value of a portfolio annually, adjusting for inflation, and have your money last to fund a 30-year retirement. The topic gets a lot of attention but is meaningless unless the investor has saved enough over their working years.
Before we can focus on how long the money will last once we stop working, it’s important to understand how much will need to be saved while working. Some new research from Wade Pfau, shows just how important it is to start saving early. Waiting until mid-career when you feel like you can really afford to start saving will require you to save significantly more than if you start saving in your 20s. The difference is so large that late starters run a big risk of not being able to save enough.
See the chart below from an August 2011 Financial Advisor magazine article reviewing Pfau’s work.
It focuses on how much you need to save to replace either 50% of your final salary or 70%. The assumption is that Social Security will provide retirement income in addition to your savings.
Clearly, the shorter the accumulation phase – and the longer the expected retirement length – the more you need to save. No surprise there. But most people probably wouldn’t guess that for an investor with expected returns based on a balanced 60% stocks, 40% bonds portfolio, that they would have to save four times as much every year if they started saving at 45 instead of 25, assuming that they retire at 65 and live to 85 and want to replace 70% of their final salary. Imagine trying to save 43.31% of your salary each year if you wait until 45 to build retirement savings.
Even with Social Security income, some people may need to replace more than 70% of their final salary in order to continue the lifestyle they prefer. Reality suggests that it’s not likely possible because it would require saving even more money or taking significantly more risk by investing aggressively with hope of earning big returns.
~ Brooks, Hughes & Jones, Partners in Wealth Management