How Can You Be Sure You Have Enough to Retire?
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If you’ve been contributing to a 401k and socking away money for retirement, you probably think you have enough. But you’d better brace yourself for the shocking truth. Unless you’ve taken into account how old you were when you started on your retirement plan, you most likely don’t.
The bottom line is that most people don’t really know how much they’ll need for retirement and without knowing that how can you be sure you’re on the right track to get there? Consider that the average American works hard and plays hard, but reaches age 65 with a median 401k balance of $110,000. Is this enough?
That depends. You’re going to need a bigger nest egg than you probably think – 10/10/4 is a handy principle you should learn.
What is 10/10/4 and how can it help?
In short you need to save at least 10% of your income for retirement. You need to have a nest egg lump sum which is 10 times your annual earnings upon retirement. Finally, you should withdraw up to 4% of your next egg in retirement to avoid outliving your money.
Put simply, 10/10/4 is a strategy that takes into account which leg of the journey toward retirement you are on and provides appropriate recommendations along the way. It’s easy to remember and can be put into practice at any time.
Rule #1
If you are in your 20’s now is the best time to start contributing to your eventual retirement. The first “10″ in 10/10/4 refers to the idea of contributing 10% per year to your 401k or IRA.
At age 25, only saving 10% of your income per year into a 401k or IRA, is required to replace 70% of your pre-retirement income, and at age 20 it’s only 8%. Note this includes any company matching, so if your employer matches 2% for example, you would only need to save 8% per year. At age 20 or 25, time is on your side.
If you did start saving at age 20 or 25, go out and celebrate, you are on the right path already. You can enjoy 90% of your income today and save 10% for tomorrow – this will take some sacrifice, but it’s doable.
However, most of us did not do that early enough.
Missing this “window” is all too common. After many years go by, you will eventually wake up and look around, and see time is the real problem. The closer you get to retirement, the harder it gets to save for it.
For example, if you start saving for retirement at age 35, you would have to save 17% of your income to achieve the same goal, a daunting task. At age 45, the percentage of your income you would have to save is 31%, which, for most of us is essentially impossible.
All of these questions assume you start at a set age and continue to save at a set rate. But in reality, life is much more complicated.
For example, what if you start saving at age 25, then move to another job; stop saving for a few years and then start again? In other words, what if your savings are not linear?
There is no calculator we have ever found that will model this real world possibility of skipping years, or playing catch-up very fast without making the estimation process extremely cumbersome.
This is where the second “10″ comes in. This means that if you missed rule #1, and your life got complicated, then you must save enough to reach rule #2, which is often much harder than starting early.
Rule #2
Rule #2 says that, by the time you are 65, you will need 10x your income immediately prior to retirement to retire at the level you want. Therefore, say you plan a lifestyle of living in the south, on a beach, but with health care coverage, some travel and a few hobbies. You’ve calculated that will require $100,000 in yearly income.
Therefore, you will need 10x that income, or $1,000,000 at age 65. The second “10″ gives you the proper perspective.
Even if you get your target income down to $80,000 before taxes, you will still need $800,000 at age 65, significantly more than $110,000.
Rule #3
Okay, now you are ready for the third and final level of 10/10/4, so what is the “4″? The “4″ means 4% is all you can take out – especially in the early years of retirement and still have confidence that your money will last throughout retirement. If you plan to take out more in the early years, you could have a big problem in volatile market times such as those we are experiencing now.
The issue is the fluctuations in the stock and bond markets are a natural occurrence. Therefore if you retire at age 65, and have 60% in equity and 40% in bonds (a moderate investment allocation), you might still have 30 more years to live and no job because there are not a lot of jobs of jobs available for a 65 year old. Yes, the problem is that we live too long after age 65 – health care advances have been too successful.
The related problem is the wide range of normal volatility in these stock and bond markets and the fact that you may end up retiring in some very difficult times for returns, such as 2000, 2001, 2007, or 2008. If the markets are in decline right at the time you retire, it is going to be much more difficult than anticipated to make ends meet.
The experts look at all the probable outcomes and the models show that a 4% withdrawal rate in the early years is the maximum rate that will preserve capital with normal volatility, until you have been retired for 5-10 years. That means that if times are really rough in the first few years that you retire, and your target was $1,000,000, you might really have to live on 4%, or $40,000 per year until you get through the bad years. That is the realty for many people who have retired recently.
Think of 10/10/4 as 3 windows into your life plan. If you are fortunate enough to have succeeded in hitting the first “10″ (saving 10% of our income and you started in your 20’s) and the second “10″ (on track to hit 10 times your income goal at age 65), then to be sure of a secure retirement work on this third and final goal, “4″.
There are practical ways to live for a few years on 4% of your retirement balance if times are tough in the early years of your retirement. You may want to work part time if needed by obtaining a skill that does have a market at age 65. Perhaps you can turn a hobby such as photography or playing a musical instrument to your financial advantage? Or build an extra cushion in your balance for these contingent years if you retire and then experience some bad stock and bond market performance in your first few years.
10/10/4 is a tool you can use at any age and it will serve you well. If you are in your 20’s sign up for 10% in your 401k or IRA and think of the 90% you get to enjoy today. Live 90% today and 10% tomorrow. You will have to make a few sacrifices but you can do it.
If you are in your 30’s or 40’s you are starting to see the problem. If you do not see progress toward the 10x goal, usually because you started too late, or skipped some years, then you will have to save much more now to catch up.
That’s why it’s so important to make sure you aren’t leaving money on the table. If you’re in your first job, make sure you are enrolled in your employer’s 401k plan. If you’ve just changed jobs, don’t leave money sitting in your previous employer’s 401k account. Instead, move it into an IRA rollover account where you have more control over fees and more investment choices.
Start today because your future depends on it.
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6 Comments so far
leave a commentThank you for the illustrative example of the “theory” of saving for retirement. I understand the desire to leave out key elements such as inflation vs prevalent interest rates and to provide a simple model.
Unfortunately, the model you provide is fundamentally broken and will not work for the populace at large.
My proof is simple.
Let us assume that everyone under the age of 30 began this process and that all of them set their target date to 65. Let us also assume that the average person will not begin to achieve any significant amount of investable income until age 20.
So basically everybody is in school until age 20. From age 20 to 65 they work and then retire until they die at age 90 (current life expectancy). This basically fits your suggestions above.
This now means that the average person spends:
- 45 years of their life working
- 45 years of their life not working
So at any given time only one of two people in the world are doing productive work that would generate energy for the entirety of the world. So basically half of the population is leeching off the other half of the population, ad infinitum. And even that is based on the shaky assumption that we could educate people by 20 in world where our problems require an ever more extensive amount of education. That’s a pretty clear case of “doesn’t scale”.
Doesn’t this sound crazy?
Speaking of crazy: Therefore if you retire at age 65, and have 60% in equity and 40% in bonds (a moderate investment allocation) This is hardly a moderate allocation for someone who plans on never working again. The only way this would be close to “moderate” was if all of the equity stocks were dividend-bearing and didn’t need to be cashed out for an extended period.
I mean really, at some point shouldn’t you just be taking out an inflation-indexed annuity rather than sitting around waiting for “the markets to recover” so that you can stop working? 60/40 at retirement? Vanguard’s Target Retirement Income Fund is much closer to a 25 / 75.
Yeah, I know that most great proofs don’t end with “Doesn’t that sound crazy”, but what are you going to do?
Jim, what type of formal research actually support this 10/10/4 theory? What type of growth numbers are you estimating to arrive at the final assumptions?
If you save 10% of your income for 45 years you’ve saved 4.5 years worth of “average annualized salary” (not even 4.5 years of your ending annual salary, just your average). Somehow, after inflation you’re planning to more than double this number and you’re planning for this to work consistently for everyone?
@Gates VP,
Just a quick note, the life expectancy in the US is only 77 years according the the CDC. This would shave almost 20 years off your retirement estimations. The average person will die 12 years after their retirement at 65. The average black male will die in their sixties, a few years after retirement. So I don’t really think it’s the case that half of us are leeching off the other half.
Also, money invested in a portfolio is still doing work even though it may not be as productive as your own human labor. If you really want your money to produce no productive work, then stuff it under your mattress.
Jess:the life expectancy in the US is only 77 years according the the CDC
Is the current life expectancy or the life expectancy for people who are currently 20 and won’t hit 77 for another 50+ years? Do we have a link for this?
Even if we change the model to 80 years (let’s give medical science a little credit), that still leaves us with 45 years of working to 35 years of not working. That leaves us with 45 people working for 35 people not working.
Imagine that you’re living in a (global) village with 80 people. 45 of those people do all of the hunting / gathering / farming / house-building. The other 35 people are either non-productive children or old people who sit around smoking pipes and eating food brought in by the other 45 people.
Either way.
If you save 10% / year for 45 years, and receive no effective pay raise between 20 & 65 (i.e.: pay raise = inflation). Then you would need ~3.25% real returns (that’s returns above inflation) for basically the entire 45 years to meet the goal of having 10x your annual income. That doesn’t sound like much, but here’s some perspective.
Right now TIPS bonds are offering 0.7% real returns (they were offering 0.0% returns just a few months ago). Real Stock market returns over the last decade are into the negative. If you earn 0% real returns one year you have to make 7.5%+ real returns the next, just to make it up, that’s not easy.
What’s more, you’re subject to a very critical period. At year 30 you have about 5x of your 10x. From year 30 to 45, you’re only going to save 1.5x (putting you at 6.5x), which means that you’re relying on 15 years of solid returns to make up that other 3.5x. If you have a 5 or 10-year drought, you could end up way short. And a 5 or 10-year drought is going to happen somewhere in those 45 years.
Finally, we made the very unsafe assumption that your “real income” doesn’t change. Realistically, your income increases over time.
According to the 10/10/4 model: “…by the time you are 65, you will need 10x your income immediately prior to retirement to retire at the level you want..”
So you need 10x your final income, not your starting or even your average income.
Let’s say you’re 20 and making 30k today. Your “10x” number is 300k. You save 10% for 10 years and save just over 1 year’s worth of income (say 31k). At the end of 10 years you make the big switch and find a new job earning 45k (again, no inflation). Awesome for you!
However, now your “10x” number is 450k, but you only have 31k in the bank. You’re behind, right? You’re at year 10, you should have at least 10% of your target number, but you only have 6.8%. So what if you continue to plow along for another 10 years and then get another pay raise to 60k? Now your 10x number is at 600k, you’re 20 years in to the plan but you’re way behind the curve. You should have saved 120k (+ interest), but you’re nowhere close to that number.
And then you have to account for medical. If you’re earning 60k but receiving 10k in medical benefits (may be low-balling in the US), you now need 700k in savings (not 600k).
You can see where I’m going with this. If you follow the 10% savings route and you also follow a normal pattern of increasing income throughout your career, the 10x goal is very difficult.
– Your increasing income makes previous savings insufficient.
– High medical expenses inflate your “10x” number.
– You need consistent returns well above inflation and you need them at the right times.
Don’t get me wrong, I’m a savings advocate. I save 10% and then some in tax-advantaged accounts.
But I make no pretenses of making it to 10x without saving more, getting lucky or making some savvy investments.
Again, the model presented above is very broken. Readers can follow this at their own risk.
I think that the graph above is more for understanding purposes. The message is simple: The longer that you wait, the more you’ll have to sacrifice to retire. I’m sure there most people aren’t planning on retiring at 65. I’m personally planning on an earlier retirement. Others (John McCain comes to mind) plan on working well into their golden years. And, what’s “retirement” anyway. Most of the people that I know, aren’t planning on sitting around doing nothing productive in retirement. I definitely see your point though. Our rate of nonworking citizens is too high as it is. There are way too many handouts in our community.
Caleb
http://www.mefinanciallyfree.blogspot.com
@GatesVP,
Your proof isn’t a proof, but I totally agree that for *everyone* to retire at something like their age 65 lifestyle, well it ain’t gonna happen. William Bernstein wrote convincingly about this in his “retirement calculator from Hell” series; he showed that, for greying societies that live off current production (can’t stockpile future food, medical care, etc), mass retirement is a demographic issue, not just a financial one. If any generation actually did all manage to save what the formula says is enough, their retirement would trigger wage inflation (more $$ chasing fewer hours of work) which would downsize those retirements to what could actually be supported. When population is increasing quickly, there are enough workers – for a while. In any event, with American attitudes toward savings (10% seems impossible to many) we won’t have to worry about this scenario!
Gates you are just as off also. The key is to save, yes having goals for targets are great. Unfortunatly life gets in the way. I counsel thousands each year and have you ever heard of: Divorce, job loss, accidents, financial fraud, and even death. I have seen all of these impact financial goals.
The key is to save as much as you can using a spending plan each month and also enjoy your life somewhere while you are saving. This is the kicker for most, finding a balance of saving and life. The 4% rule is the key is a good rule of thumb but even better is Ray Lucias “Buckets of Money” plan which is by far the best and almost bullet proof. I have looked at all plans out there and none come close. So your Annuity would be one piece of the puzzle but you need a simple Buckets of Money stategy for true success in retirement.