December 2007

Putting away enough money for retirement may be easier—or harder– than you think, says one of the best-known developers of modern portfolio modeling tools.

New savings guidelines adjust for current savings, age, Social Security, and projected investment returns.

Yale Professor Roger Ibbotson and associates at his investment research firm have used modern simulation techniques to develop national savings rate guidelines to help workers at various ages determine whether they are on track for retirement.

Ibbotson contends that traditional methods of calculating an appropriate savings rate may overestimate a retiree’s income needs, forcing workers to make more radical cuts in their pre-retirement lifestyles than are necessary.

One traditional method says a worker will need to replace 80% of his gross working income in order to retire comfortably. But Peng Chen, an Ibbotson associate, says “using net income is a realistic approach.”

Current savings count
For instance, a worker who is saving $10,000 a year from an income of $100,000 a year should figure he needs retirement income of 80% of his net income after savings, that is, 80% of $90,000, not 80% of his $100,000 gross income, Chen says.

The guidelines developed by Ibbotson and Chen assume that a worker needs to accumulate enough money to buy an inflation-indexed lifetime annuity upon retirement that would fill the gap between Social Security and 80% of pre-retirement net income.

“We’re not suggesting that everyone should put all of their savings in an immediate annuity,” Chen says. Instead, they use an annuity formula as “a reasonable and conservative way to estimate how much income the savings can sustain.”

Age and income rule
Higher income workers need to save more, because there is a cap on Social Security benefits and their gap will be larger. Older workers who haven’t saved significant sums previously also will have to save more, or retire later and adjust their retirement spending.

Older workers have to save more.

Here are some examples of the Ibbotson saving guidelines. For each age, different savings rates are given based on income. Also, a second percentage is given showing how much the savings rate can be reduced for each $10,000 already socked away. For example, a 30-year-old with $40,000 in income should save 10% of income, but can reduce that amount by 0.79% for each $10,000 already saved. If he had saved $30,000, he would multiply 0.79 times 3. The result, 2.37%, would be subtracted from the base savings rate of 10%. This worker, then, should save 7.63% of his income.

Age 30: Income $60,000, 11.8% savings rate, reduce by 0.54% for each $10,000 saved. Income $80,000, rate 13.6%, reduce by 0.42%.

Age 40: Income $60,000, rate 17.6%, reduce by 0.57%. Income $100,000, rate 21.4%, reduce by 0.35%.

Age 50: Income $60,000, rate 26.2%, reduce by 0.64%. Income $100,000, rate 32.2%, reduce by 0.39%. Income $120,000, rate 35%, reduce by 0.33%.

Age 55: Income $60,000, rate 32.6%, reduce by 0.71%. Income $100,000, rate 40.2%, reduce by 0.43%. Income $120,000, rate 43.6%, reduce by 0.36%.

Chen notes that it is important to start early. The recommended rate for those who start saving at 25 more than doubles for those who wait until age 45 to begin.