Thursday, July 9, 2009

The Simplest Financial Plan of All

A very simple financial plan--the simplest of all, in fact--is to save a significant percentage of your income. If you save about 15% to 20% of your pretax earnings, work for 30 or more years, and invest in a reasonably well-diversified portfolio, you'll have a good chance of maintaining your pre-retirement standard of living during your golden years. It's not easy to save this much. But if you can, you'll probably build a good-sized portfolio while keeping your standard of living under control and sustainable in your golden years. If you save a smaller percentage of your pretax earnings, like 5% or 10%, you'll have to make some cutbacks in retirement (although you'd still be better off than most Americans).

One advantage of the percentage of earnings approach is that you won't need to fuss around with calculators that give you seemingly impossible retirement targets in the millions of dollars and which need to be revised every year or two to account for inflation. Any reasonable estimation of your needed retirement savings will result in a figure in the high hundreds of thousands or in the millions. These numbers seem so intimidating and impossible that many people don't even bother to start saving. That's a mistake. Forget about the seemingly impossible dollar amount and instead focus on saving a percentage of this year's income, then next year's income, and so on. After a few years, saving becomes easier and your wealth will grow visibly.

Another advantage of using a percentage of your earnings as a saving target is that you won't have to budget specific expenses. You can spend as much as you like on lattes, clothes, cars and whatever, so long as you save the requisite percentage of your earnings. You can still indulge and spoil yourself in some ways, even excessively, provided you feed the retirement savings. No need to input each day's expenditures into your PC, or debate whether chocolate is an extravagance or a necessity. Anything goes, as long as you fund your retirement adequately.

Saving isn't easy. But a simple financial plan will make it easier.

If you want a more detailed explanation of why the percentage of earnings method works, keep reading. But . . .

Warning, Alert, Danger: Math lurks below.

The simplest financial plan of all is based on a straightforward idea: the more you save, the less you spend today and the less extravagant your current lifestyle. Because you have a less expensive lifestyle, you’ll need less money to maintain that lifestyle in retirement, yet will have more resources today to save for a nice retirement. In other words, by controlling your spending today, you leverage your ability to save for a comfortable retirement. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle.

Look at the numbers. If you’re spending 100% of your current income, you’ll save nothing for retirement, and have just Social Security benefits. Get used to eating dog food.

If you spend 95% of your pre-tax earned income (we count taxes as spending because you don't save the taxes you pay), and save 5% in a 401(k) account—adjusting your contributions upward annually for inflation--you’ll have a decent sized nest egg after 30 years. If we assume annual investment gains of 7% compounded, you'll have enough at age 65 to start withdrawing an amount equal to about 19% of your average annual pre-retirement income. (This assumes you're drawing down 4% of the initial value of your retirement assets per year in retirement, which is about as much as you'd want to withdraw if you don't want to outlive your money.) You can use an Internet financial calculator like's ( to do these calculations. Adding 19% of your working years' annual income to your Social Security benefits may not sound like a lot, but it’s a damn sight better than zero.

If you're middle class, Social Security could amount to about 30% of your pre-retirement income. With another 19%, you'd retire on a total of 50% or so of your average annual pre-retirement income.

If you save 10% of your earned income in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income, starting at age 65 (assuming a similar 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d be withdrawing enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today leverages your ability to save and to maintain your current lifestyle in retirement. Add the 30% or so that Social Security would provide if you're middle class, and you'd retire on about two-thirds of your average annual pre-retirement income.

Using the same assumptions, if you save 15% of your earnings each year, then you'd be able to withdraw about 57% of your average annual pre-retirement income during your golden years. Because you'd have been living on 85% of your income, the withdrawal would approximate 67% of your average annual pre-retirement spending. If you're middle class, add 30% or so for Social Security, and you would be able to spend about as much each year in retirement as you did, on average, before retiring.

If you can save 20% or 25% of your earned income per year, you could actually end up with more lifestyle in retirement than you had while working. Let the good times roll.

It’s important to note that these numbers are for your average annual earnings over the course of your life. Your average annual income for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off with lower incomes early in their careers and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher rather than lower percentage. At least 20% of your earned income would be a good idea. We also don't count investment earnings saved, since that is embodied in the compounding of earnings that leverages the growth of your savings.

What’s the right level of saving? That’s for you to decide. Each of us has a point where the trade-off between saving and current spending feels right. It won’t be the same for everyone. Pick a point along the continuum that makes you comfortable, and stick to the savings plan. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would be farther along the continuum toward a modest lifestyle now and a higher level of savings. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. While 15% has a good chance of getting you there, 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is quite possible since go-go years in the stock market--like the 1990s and 2000s up to 2007--are often followed by long periods of below average performance). Also, if you have fewer than 30 years to go before retiring, save more, like 20%, if you want to avoid a drop in lifestyle during your shuffleboard years.

Good luck.

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