Friday, November 10, 2006

How to live on 15%...

Following my series on Dave Ramsey, is 15% enough to save for retirement? There are many factors which weigh into this calculation. First your age, if you are 25 then probably. If you are 45, I have my doubts. Second, do you have anything saved and if so how much? If you are 45 with ZERO start worrying. If you are 25 and have zero, well save faster. Third will you have a defined benefit plan (pension) where your company will pay you a set amount every month? This could offset not having as much cash saved for retirement. Of course with companies like United, Enron, Ford, etc all cutting their pensions, if it's with a private company I don't know how much I would count on getting the full benefit. Finally it depends on when you want to retire, for sure 15% is not enough if you want to retire earlier than 65 even if your 25. You will need to cover your medical and any other health issues before 65 when medicare kicks in.

Now to address specifically if 15% is enough. With two people working, you are allowed to save $4k/annually for a Roth IRA and $15k/annually into a 401k. This equals $38k/year into tax deferred retirement accounts. So for our calculations we'll be putting everything into a tax deferred or non-taxable account.

Consider if you are 45 years old with no savings, well every $1 million dollars in savings = $40k/year living. This assumes you withdraw 4% which is the amount estimated by all economists to not outlive your portfolio. If you are making $60k/annually you need a $1.5 million porfolio to replace your income without Social Security. But let's assume you will get 20k/year from SS at 65, and will retire at 65 (full retirement age is actually 67).

So you need $1 million in today's dollars and you have 20 years. If you save 15% of $60k that's $9k/year into a Roth/401k. Assuming an 8% return on investment (DR says 12% he's seriously crazy), you will have $425,800. That's 50% less than you need to generate your income for the rest of your life. According to the MSN calculator you should be saing $21,137/annually into your 401k/Roth IRA for 25 years to reach $1.25 million. That means you should be saving 35.2% of your gross income.

So how do you live on Dave Ramsey's fictional 15% savings? Well his 12% earnings sound real good about now. But it's not going to happen, and if you follow his investment advice you could lose big (25% aggressive growth, 25% growth, 25% small cap, and 25% international). Where are the bonds? Also I'm guessing he's assuming a lower standard of living when you retire, not necessarily true if you are unhealthy or want to travel. Medicare doesn't cover a lot of things, so perhaps replacing 100% of your income is not unrealistic.

Let's run the numbers again if you are 25 and 35 years old. But this time these people get no SS so they need a $1.5 million portfolio, assuming 8% returns. The 25 y.o saving $9k/annually will have $2.5 million saved for retirement. To save only $1.5 million he will need to only save $5349/annually or 8.9% for 40 years. Of course not many 25 y.o make $60k.

Now the 35 y.o saving for 30 years will have $1.077 million saved, enough to have a slightly cut back lifestyle. Now he only needs to save $12,530/annually or 20.8% of his $60k salary to reach $1.5 million for 30 years.

So it appears if you have a longer time frame you are able to meet DR's goals of 15% savings. It's also assuming that the 25/35 year old is making $60k (not peaking out at $60k) and can easily save 15% on top of saving for a DP for a mortgage or is already carrying a mortgage. Another issue is that I assumed SS wouldn't be available for these younger people, is that correct? Maybe/maybe not, but I would use SS as icing on the cake, not supplemental income. A lot of reform is coming on both Medicare and SS so I don't see it being a guaranteed income. Another issue is saving for college if you delayed having kids or have lots of children. This will be addressed in another column.

So the moral of 15%? It's enough if you are young and make a good income. It's not enough if you are older and don't have much saved. Rules of thumb are typically more applicable the younger you are, the older you are the more you need to rachet up that savings. And 15% is great if you were saving nothing before.


mOOm said...

Is Dave Ramsey talking nominal returns and you are talking real returns? With some leverage 12% is clearly not wild as a nominal return though most people won't get it because they invets badly.

Living Almost Large said...

No it's a regular 12% return after tax, not nominal. Also he advocates pulling 8% out of your portfolio a year for living during retirement. Which I think is rather large chunk at any given time.

JW said...

Unfortunately, Dave Ramsey doesn't really deal with the issue of retirement savings after 40 very much. And, after some thought its not difficult to agree with you that the 15% contribution would not sufficient for someone our age.