A New Rule of Thumb for Retirement Savings

This article published with permission from InvestmentU.com.

There have been many popular rules of thumb about how much one would need to live comfortably during retirement. One common axiom was that you would need about 70% or 80% of your pre-retirement income. So, if you made $50,000 right before retiring, you should need either $35,000 or $40,000 of income in retirement.

These percentages depend on assumptions of how many expenses you’ll still have after you stop working. These rules guess that you’ll probably no longer have a mortgage or have any kids living at home. Many investment gurus also take into account that you’ll no longer be socking away money for retirement and that you’ll have perfect health. As you can see, this isn’t based on any science. These are pretty broad assumptions.

This sort of planning is all about destination, but doesn’t give us a roadmap so we can get there. Last year in an NPR poll, the Robert Wood Johnson Foundation and the Harvard School of Public Health found that many Americans are finding it difficult to get their heads around the retirement concept. For the most part, they don’t believe they have saved enough and they’re scared to death that they’ll live too long.

Well, last week an announcement was made with a new rule of thumb. And this process gives you a better approximation of how to get there rather than just telling you where you should end up.

Fidelity’s guidelines

Fidelity Investments last week outlined a pretty simple set of savings guidelines to help investors determine if they’re on track to achieve their retirement goals. Their retirement needs are based on current income. However, this rule of thumb comes with a little twist. It’s Fidelity’s belief that most investors should shoot to save at least eight times their ending salary to meet their retirement needs.

Fidelity strongly makes the point that we’re all different. Everyone has a unique situation. But if you come up with a rule of thumb, you have to make some generalizations. This end game is that the average investor could replace 85% of his or her working income by putting away eight times that salary. To meet this goal, the following should happen:

• Workers should have saved about one times their salary at age 35

• Three times their salary by the age 45

• Five times their salary by the age 55

Here’s how the numbers should look every five years:

James M. MacDonald, President of Workplace Investing at Fidelity Investments, stated:

“We believe these savings targets offer a rule of thumb to help employees get engaged in retirement planning by making it simpler and more achievable, but we recognize many individuals may need more than 8x their ending salary in retirement based on their lifestyle.”

Digging deeper inside the numbers

Fidelity’s retirement guideline is based on a worker using his workplace retirement plan starting at the age of 25.

The plan assumes that this same worker will work and save continuously until age 67.

This person will live to the age of 92.

The ending retirement pool would include workplace retirement plans, IRAs and all other savings.

The investor will make non-stop 6% of salary contributions each year to their workplace plan.

The contribution will increase 1% per year until he gets to 12% (this also assumes an ongoing 3% annual employer contribution).

Fidelity Investments’ models came up with a lifetime average annual portfolio return rate of 5.5%.

Social Security payments are used to figure out the replacement income ratio of 85%.

The investor’s salary increases by an average of 1.5% every year over general inflation.

It assumes no breaks in employment or savings

MacDonald went on to say:

“The two factors that have the greatest impact on retirement savings over time are starting early and saving consistently… Having worked with millions of workplace retirement plan participants, we know that positive behaviors lead to positive outcomes. Having age-based targets provide benchmarks to help retirement savers stay on track toward their ultimate goal.”

Having somewhat of a gauge

What I believe is different or even beneficial about this rule of thumb is that you can make use of it any time during the retirement journey. You can check up and see where you stand at any point during your retirement planning process. You might find yourself on track or ahead — or maybe even in deep trouble. But at least you have somewhat of a gauge.

Where this becomes a rule of thumb is in the idea that it doesn’t matter so much where you start, but how you finish, with eight times the salary as a nest egg.

And using their information as a foundation, this is what most of us want to know.

Beth McHugh, Vice President of Thought Leadership at Fidelity Investments, stated among workers who call for retirement guidance, “The number one question we get from participants when they call is, ‘Am I on track?’”

And as Jeanne Thompson, Vice President of Market Insights at Fidelity, chimed in, “It’s not like you can start at age 25 or 30 and set it and forget it. As you age and move along in your career, you need to constantly re-evaluate your savings level and your asset allocation… to make sure that for the rule of thumb, you are where you are supposed to be.”

Remember these are rough guidelines. So if you want a little more out of retirement, eight times your ending salary may not be enough…

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.