Is Saving 10% Enough?

A common rule of thumb when planning for retirement is to save 10% of your gross income during your working years. Since this rule of thumb has been around for a long time, it is logical to question whether it is still an appropriate guideline.

For many, it may be a moot question since overall personal savings don't come close to that 10% figure. Personal savings as a percentage of disposable income are hovering at historically low levels, 0.9% in 2004 (Source: The Regional Economist, July 2005). There is some debate over how much significance to place on the decline in the personal savings rate, since it only measures what percentage of disposable income is saved each year. It does not factor in changes in wealth attributable to gains in investments and real estate. But the same methodology was used in the 1960s, 1970s, and 1980s, when the personal savings rate was in the 8% to 10% range (Source: The Wall Street Journal, July 20, 2005).

Despite overall trends, you still control how much to save for your retirement.

So, is 10% a good guideline?

Several trends suggest that it is probably on the low side:

• Fewer individuals are covered by defined-benefit plans. The 10% guideline anticipated that a retiree would receive a defined-benefit pension as well as Social Security benefits. But now, only 20% of the work force is covered by a defined-benefit plan (Source: InvestmentNews, May 9, 2005), with 80% of the work force without a pension.
• The Social Security system will face increasing pressure in the future. Due to the unprecedented number of baby boomers who will be retiring in the near future, there will be fewer workers to pay the benefits for each retiree. In 1950, 16 workers were paying for each retiree's benefits. Currently, there are 3.3 workers supporting each retiree, which is expected to drop to only 2 workers for each retiree in 40 years (Source: Social Security Administration, 2005). By 2042, unless changes are made to the system, benefits will need to be reduced by 27% to equal revenues collected (Source: Social Security Administration, 2005).
• Life expectancies are continuing to increase. Average retirement ages have been decreasing while life expectancies have been increasing. Today, at age 65, the average life expectancy is 82 years for a man and 85 years for a woman, compared to 78 years for a man and 81 years for a woman in 1950 (Source: The Wall Street Journal, July 20, 2005). Thus, the average retiree has fewer years to accumulate savings, and those savings must last for a longer period of time.
• Plans for retirement have changed. Another commonly heard retirement planning rule of thumb is that you'll need 70% of your preretirement income after retirement. However, that guideline assumes a relatively inactive retirement lifestyle. Increasingly, retirees view retirement as a time to travel extensively or engage in expensive new hobbies. Thus, more and more retirees are finding little change in their income needs after retirement.
• Stock yields are expected to be modest in the foreseeable future. Historically, stock yields as measured by the Standard & Poor's 500 have averaged 10.4% annually over the period from 1926 to 2004.* But with price/earnings ratios at historically high levels, dividend yields at historically low levels, and economic growth uncertain, even those average returns are in question for the foreseeable future.

All these trends point to the fact that future retirees will be responsible for providing more of their income for a longer period of time. Thus, you should consider higher, not lower, savings amounts. A recent study concluded that workers who start saving in their 20s should save 10% to 15% of their gross income for their entire working life. Wait until your 30s, and you should save 15% to 25% of your annual income. Those who wait until their 40s will need to save 25% to 35% of their income (Source: U.S. News & World Report, 2005).

If that seems like too much to save, just think about how many years you expect to work compared to how many years will be spent in retirement. Assume you start working at age 22, work until age 62, and then die at age 82. Thus, you work 40 years and are retired for 20 years - for every two years you work, you need to support yourself for one year in retirement. If your retirement expenses don't go down and you don't have a defined-benefit pension, you'll need to save significant sums to support yourself for that length of time. One study found that to replace just 70% of your preretirement income, you would need to save 14% of your income every year during that 40-year period (Source: Barron's, September 5, 2005).

Contrast that situation with a typical scenario in 1950. At that time, the average retiree worked 47 years before retiring for nine years. Thus, that person worked over five years to support one year of retirement, which required annual savings of 6% of income.

For many people, then, the answer may be to extend their working years. In the above example, if you wait until age 70 rather than age 62 to retire, you will work for 48 years and be retired for 12 years. This would require annual savings of 7% to replace 70% of your preretirement income.

While preretirees may not have the mathematics down pat, many are realizing that working longer, rather than retiring earlier, may be the only way to ensure they don't run out of retirement funds. Almost all recent surveys of baby boomers indicate that the majority expect to work at least part-time during retirement. One recent survey found that 80% expect to work during retirement (Source: Money, August 2005).

These stark realities don't mean you can't retire, just that you need to plan carefully. Thus, you should start saving as much as possible, as soon as possible, for your retirement. Waiting even a few years to start saving can significantly increase the amount you need to save.

Trying to gauge whether your retirement savings are on track?
While there's nothing like going through a thorough analysis, you can take a quick look by adding up all your retirement assets and multiplying that balance by 4% or 5%. This withdrawal percentage should ensure that your retirement assets last at least 30 years (Source: U.S. News & World Report, 2005).

* Source: Stocks, Bonds, Bills, and Inflation 2005 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.