How Much Should I Contribute to Retirement?
A question I’m sure to address during employee retirement presentations is, “How Much Should I be Contributing?”. Quick internet search led me to two popular answers.
Whatever you need to contribute to get the match from the employer,
10-15% of your compensation.
As with most questions around financial planning, the answer should really be, “it depends”. We all know it is important to save for retirement, but knowing how much is enough is the real issue and typically there is more work involved than saying 10-15% of your pay.
In this article, I will address some of the variables at play when coming up with your number and provide detail as to why the two answers previously mentioned are so common.
Expenses and Income Replacement
Creating a budget and tracking expenses is usually the best way to estimate what your spending needs will be in retirement. Unfortunately, this is time-consuming and is becoming more difficult considering how easy it is to spend money these days. Automatic payments, subscriptions, payment apps, and credit cards make it easy to purchase but also more difficult to track how much is leaving your bank accounts.
Most financial plans we create start with the client putting together an itemized list of what they believe they spend on certain items like clothes, groceries, vacations, etc. A copy of our expense planner template can be found here. These are usually estimates as most people don’t track expenses in that much detail. Since these are estimates, we will use household income, taxes, and bank/investment accounts as a check to see if expenses appear reasonable.
What do expenses have to do with contributions to your retirement account now? Throughout your career, you receive a paycheck and use those funds to pay for the expenses you have. At some point, you no longer have the paycheck but still have the expenses. Most retirees will have access to social security and others may have a pension, but rarely does that income cover all your expenses. This means that the shortfall often comes from retirement accounts and other savings.
Not taking taxes, inflation, or investment gains into account, if your expenses are $50,000 per year and Social Security income is $25,000 a year, that is a $25,000 shortfall. 20 years of retirement times a $25,000 shortfall means $500,000 you’d need saved to fund retirement. Once we have an estimate of the coveted “What’s My Number?” question, we can create a savings plan to try and achieve that goal.
Cash Flow
As we age, some of the larger expenses we have in life go away. Student loan debt, mortgages, and children are among those expenses that stop at some point in most people’s lives. At the same time, your income is usually higher due to experience and raises throughout your career. As expenses potentially go down and income is higher, there may be cash flow that frees up allowing people to save more for retirement. The ability to save more as we get older means the contribution target amount may also change over time.
Timing of Contributions
Over time, the interest that compounds in retirement accounts often makes up most of the overall balance.
For example, if you contribute $2,000 a year for 30 years into a retirement account, you will end up saving $60,000. If you were able to earn an annual return of 6%, the ending balance after 30 years would be approximately $158,000. $60,000 of contributions and $98,000 of earnings.
The sooner the contributions are in an account, the sooner interest can start compounding. This means, that even though retirement saving is more cash flow friendly as we age, it is still important to start saving early.
Contribute Enough to Receive the Full Employer Match
Knowing the details of your company’s retirement plan is important. Most employers that sponsor a retirement plan make contributions to eligible employees on their behalf. These contributions often come in the form of “Non-Elective” or “Matching”.
Non-Elective – Contributions that will be made to eligible employees whether employees are contributing to the plan or not. These types of contributions are beneficial because if a participant is not able to save for retirement from their own paycheck, the company will still contribute. That being said, the contribution amount made by the employer, on its own, is usually not enough to achieve the level of savings needed for retirement. Adding some personal savings in addition to the employer contribution is recommended.
Matching – Employers will contribute on behalf of the employee if the employee is contributing to the plan as well. This means if the employee is contributing $0 to the retirement plan, the company will not contribute. The amount of matching varies by company, so knowing “Match Formula” is important to determine how much to contribute. For example, if the matching formula is “100% of compensation up to 4% of pay”, that means the employer will contribute a dollar-for-dollar match until they contribute 4% of your compensation. Below is an example of an employee making $50,000 with the 4% matching contribution at different contribution rates.
As you can see, this employee could be eligible for a $2,000 contribution from the employer, if they were to save at least 4% of their pay. That is a 100% return on your money that the company is providing.
Any contribution less than 4%, the employee would not be taking advantage of the employer contribution available to them. I’m not a fan of the term “free money”, but that is often the reasoning behind the “Contribute Enough to Receive the Full Employer Match” response.
10%-15% of Your Compensation
As said previously, how much you should be contributing to your retirement depends on several factors and can be different for everyone. 10%-15% over a long-term period is often a contribution rate that can provide sufficient retirement savings. Math below…
Assumptions
Age: 25
Retirement Age: 65
Current Income: $30,000
Annual Raises: 2%
Social Security @ 65: $25,000
Annualized Return: 6%
Step 1: Estimate the Target Balance to Accumulate by 65
On average, people will need an estimated 90% of their income for early retirement spending. As we age, spending typically decreases because people are unable to do a lot of the activities we typically spend money on (i.e. travel). For this exercise, we will assume a 65-year-old will need 80% of their income throughout retirement.
Present Salary - $30,000
Future Value After 40 Years of 2% Raises - $65,000
80% of Future Compensation - $52,000
$52,000 – income needed to replace
$25,000 – social security @ 65
$27,000 – amount needed from savings
X 20 – years of retirement (Age 85 - life expectancy)
$540,000 – target balance for retirement account
Step 2: Savings Rate Needed to Achieve $540,000 Target Balance
40 years of a 10% annual savings rate earning 6% interest per year, this person could have an estimated balance of $605,000. $181,000 of contributions and $424,000 of compounded interest.
I hope this has helped provide a basic understanding of how you can determine an appropriate savings rate for yourself. We recommend reaching out to an advisor who can customize your plan based on your personal needs and goals.
Rob Mangold
About Rob……...
Hi, I’m Rob Mangold, Partner at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.
