What Percentage of Salary to Save for Retirement

There’s a lot of debate about “the magic number” – the term used to describe how much money you need to save to live a financially comfortable retirement. A quick search reveals wildly different ideas about what your retirement savings should look like when you finally stop working. Additionally, you can find free online calculators – most showing little agreement with one another.

Why so much disagreement? Because making plans for the future depends on a lot of unknown variables. You don’t know how long you’ll be able to work, how well the world’s investment markets will perform, which life events might happen to you or how long you will live.

"Saving for retirement is likely not the only financial goal you have on your plate. You may be thinking about buying a house, starting a family, opening a business or any number of other things. All of these goals are clamoring for a slice of your paycheck, so setting your priorities and shifting your savings percentages becomes a highly personalized activity," says Eric Dostal, J.D., CFP®, advisor, Sontag Advisory, LLC, New York, N.Y. Any calculation is an educated guess at best.

What is possible, however, is to operate under some rules that make assumptions. For instance, you could assume that you’ll have a steady income until age 65.

That’s exactly what drives many of the leading theories.

Academic studies of retirement saving often throw around the term replacement rate. Simply, it’s the percentage of your salary that you’ll receive in retirement benefits after you stop working. If you made $100,000 a year when you were employed and receive $38,000 a year in retirement payments, your replacement rate is 38%. (Needless to say, this figure is much too low for most people.)

"A replacement rate gives you a target in terms of how much you need in retirement to approximately maintain your current standard of living. The variables that go into a replacement rate include savings, taxes and spending needs," says Mark Hebner, founder, and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of "Index Funds: The 12-Step Recovery Program for Active Investors."

Now that you understand replacement rate, let’s look at some research. The Center for Retirement Research at Boston College looked at what various types of people have to save to achieve a replacement rate of around 70%. That's the overall amount people need to retire at a comfortable level, according to the study's authors, Alicia H. Munnell (the center's director) and her associates Anthony Webb and Wenliang Hou. The figures varied depending on whether someone was replacing an income that was low (80% replacement rate needed), middle (71%) or high (67%).

They found that individuals earning the average wage would have to save 15% of their earnings every year to meet a 70% replacement rate at age 65. The biggest factor in the calculations was age – when you started saving and when you ended. Start saving at 25 and you only need to earmark 10% of your annual salary to retire at 65; if you wait until 70 to quit working, you'd have to save only 4% annually.

The numbers are much worse for those who start late. If you waited until age 45 to start saving, you would need to put aside an unrealistic 27% of your salary for retirement. This would pretty much force you to work until age 70 so you could save a more realistic 10% annually. "Time can be your greatest friend or worst partner, so use it wisely. A 25-year-old who contributes $5,000 to a retirement account, will not touch the money for 43 years and gets an average return of 8% should have approximately $1.67 million," says Peter J. Creedon, CFP®, CEO of Crystal Book Advisors, New York, N.Y. "If you wait until age 35 and contribute the same amount and get the same return, you would have a little under $730,000."

In another study, Wade D. Pfau, CFA, professor of retirement income at The American College, found that historical data over nearly the past century indicate that a person would have to save 16.62% of his or her salary to retire 30 years after beginning the savings plan with enough money to fund a replacement rate of 50% from his or her "accumulated wealth." (Unlike the Boston College researchers, Pfau didn’t include Social Security income or "any other income sources" in his 50% calculation. Adding in Social Security and, say, pension income would move the replacement rate significantly higher.)

If all of these facts and figures seem a little confusing, simply remember this: Start saving for retirement as early as possible.

Pfau's research highlights two other important variables. First, he notes that over time the safe withdrawal rate – the amount you can withdraw after retirement to sustain the fund for 30 years – was as low as 4.1% in some years and as high as 10% in others. He believes that "we should shift the focus away from the safe withdrawal rate and instead toward the savings rate that will safely provide for the desired retirement expenditures."

Second, he assumes an investment allocation of 60% large-cap stocks and 40% short-term fixed-income investments. Unlike some studies, this allocation doesn’t change throughout the 60-year cycle of the retirement fund (30 years of saving and 30 years of withdrawals). Changes in the person’s portfolio allocation could have a significant impact on these numbers, as can fees for managing that portfolio. He notes that "simply introducing a fee of 1% of assets deducted at the end of each year would increase the baseline scenario’s safe savings rate rather dramatically from 16.62 % to 22.15%."

This study not only highlights the pre-retirement savings needed but emphasizes that retirees have to continue managing their money to prevent spending too much too early in retirement.

These studies calculate savings for individuals, but what about families? Parents with young children have to save for their college – ideally at least $2,500 per year, per child, from birth – to cover the cost of a public university. Costs associated with children make saving for retirement even more daunting. 

But there’s good news: Retirement savings for a husband and wife don’t compute to twice the cost of what an individual needs. Married couples share many significant expenses – a home, for example.

For people who start saving early and take advantage of employer-sponsored plans such as 401(k)s, meeting saving goals isn’t as daunting as it may sound. Employer matching contributions could significantly reduce what you need to save per month. "If a company is matching your contributions, not only are you contributing pre-tax, but you’re also getting additional free money," says Dan Timotic, CFA, managing principal at T2 Asset Management, LLC, Oakbrook Terrace, Ill.

"Employer matches are a great way to amplify your retirement savings. Imagine that you save 3% of your income putting it into your company 401(k) plan and your employer matches up to 3% of your savings, dollar for dollar. In your first year, you will make a 100% return on the amount you saved. Where else can you get those kinds of returns with very little risk?" says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.

There’s no way to accurately forecast your retirement needs since nobody knows what their future holds. However, educated assumptions based on historical data yield fairly clear benchmarks. Aim to save 16% of your annual salary if you’re early in your career. If you make $50,000 per year, save $8,000 per year or about $666 per month. A tough task? Maybe. But if your employer is matching your savings, that $666 could be $333 if the company matches your contributions dollar for dollar.

 It will take discipline, but it’s better to sacrifice while you’re able to work instead of reaching retirement with too little money and too few options.