Safe withdrawal rate is the percentage which you can withdraw from your portfolio each year in retirement, adjusted for inflation, at which you shouldn't run out of money before dying. But how much of your income do you need to save for retirement?

Wade Pfau, a finance professor, published a paper this year in which he discussed the concept of a safe savings rate.

How Much Do I Need to Save for Retirement?

A reader recently posted a comment asking how much he needed to save each year in the accumulation stage of his life. Although the answer we are tempted to give is “as much as you can” (which is probably accurate from a behavioral perspective), from an academic and theoretical perspective, the answer is that it depends. But Professor Pfau's paper nails it down about as well as one can.

The real meat of the paper is Table 1, which is reproduced here.

Let's look at the two extremes to get an idea of what the table is actually saying.  First, if you only work and save for 20 years, then want to live in retirement for 40 years on 70% of the salary you were making when you were working, and you're only willing to use a portfolio that is 40% stocks, then you need to save 66% of your income each year.  On the other hand, if you're willing to work for 40 years, have a retirement of 20 years, live off 50% of your final salary, and use an 80/20 portfolio, then you only need to save 6.3% of your salary.

There's obviously a big difference between 6% and 66%.  Most of us are probably somewhere in the middle.  A more reasonable assumption is 30 years working, 30 years retired, live off 50% of final salary in retirement (remember you no longer have to pay as much in taxes or save for retirement and you'll likely get something from social security) and use a more standard 60/40 portfolio.  This reveals you need a savings rate of 17%.  Now that's off your gross income.


Safe Savings Rate Recommendation

This is the basis for our usual recommendation to save 15-20% of your income.  10% probably isn't enough.  25-30% is for those who want to retire early. If you want to retire really early (before 50), you'd better be pretty darn thrifty both before and after retirement.  Even with only living off 50% of your salary (remember social security won't kick in for a decade or more after you retire) and investing aggressively, you'll still need to save over 1/3 of your income during your working years.

The Importance of Increasing Your Savings Rate

For a “young” investor (meaning one who has a low account balance relative to the amount he will need to retire, say a ratio of 25% or less) his savings rate has a much greater effect on the amount of money he will have to spend in retirement than his return. Rather than focusing on how to eke out a few more percentage of return, he would be much better off focusing on how to increase his savings rate.

An example:
An investor with $10,000 who saves $5000 a year expects to have $167,000 15 years from now if he pulls off an 8%/year return. If he can increase that return by 1%, he would have a total of $182,000. However, if he could increase his savings by just $2000/year, he would end up with $222,000. He would get much more “bang for his buck” by saving more rather than trying to get a higher return.

The opposite is true for a “mature investor” (again defined as someone with a high percentage of what he would need to retire on.) Let's say we have a 60 year old investor with 5 more years until retirement. He has a nest egg of $1,000,000. He is currently saving $20,000/year and expects an 8% return from his portfolio. This will only get him to $1.59 Million. Where is the bang for his buck now? If he saved another $5K/year, he would end up with $1.62 Million. But if he could increase his return by 1%, he would end up with $1.66 Million. Clearly the bang for his buck is in maintaining/increasing his return.


How to Increase Your Savings Rate

The following are some steps you can take to increase your savings rate:


Increase the Amount of Money You Make

It is much easier to save 25% of $200K than it is to save 10% of 40K, even while paying a higher tax rate. This can be accomplished by further schooling/training to upgrade your skills, changing jobs when opportunities to make more money arise, and taking additional jobs/working overtime.


Save Your Raises

Cost of living and standard raises are frequent with many jobs. Although we often need to gradually increase our spending to maintain our lifestyles, often times we do not need to increase our spending as much as our income increased.


Keep Fixed Expenses Low

The less you are obligated to spend, the more you have the option to save. Then you can make conscious decisions between spending and saving each month. Avoid contracts you can’t get out of if your finances turn sour, such as cable, cell phone, boat payments, large mortgages etc. Try to rent your lifestyle when possible, rather than buy it.


Limit the Cost of Your House and Cars

Most people calculate out their mortgage payment when they opt for a bigger, nicer house, but they forget that they also have to pay more in taxes, utilities, repairs, landscaping, furnishings, and upgrades on that bigger, nicer house. Because your house is a big ticket item, saving 25% on that will free up much more cash flow than eating out 25% less. To make it worse, most of these expenses are fixed expenses.

saving for retirement

Likewise with cars, a great deal of money is lost buying and financing these depreciating assets. The older you buy a car, the less you will pay in financing costs, depreciation, insurance, and sometimes even repairs because you may be less likely to repair unimportant features of an old car, such as dings in the bumper or a power mirror that works poorly. The savings in repairs and gas of a new car do not come anywhere close to overcoming these costs.


Watch Out for the Latte Factor

Even small costs can add up over time, especially when considered in light of decades of compounding. The classic example is the $5 latte. If you save that $5 a day ($180 a month, $1825/year) and earn 8%/year on it, it will be equal to $482K in 40 years. Consciously decide what you want to spend your money on, and spend it on that which brings you the most happiness, and save the rest.


Calculate your savings rate each year. Studies show that we consciously and subconsciously strive to improve in those aspects which we measure.

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