We hear “Save 10% of your income” as being a reasonable target. Who knows what happens if you do? Hands up if you know.
I have composed an example based on Mincer’s earnings function, a common model for a question like this, a starting salary of $40,000 at age 24 and retirement at 60. I have further supposed that inflation is always 3% and investment yield after taxes is 7%. An ambitious yield but using a Tax Free Savings Account it is possible.
How much will be there at 60?
About $1.75 million. Quite nice, but in perspective, perhaps we can learn more.
Compared to total career earnings, that is a little less than 29%. Earn $6 million keep less than a third. It is about five times final year income.
If you would like to accumulate as much as you have earned, the savings rate must be higher. There will be tax effects too because the new level exceeds the TFSA limit. With 1% going to taxes, the saving percentage must be 41%.
This is all very sterile. Planning requires more:
- How much do you need at retirement?
- How long after retirement will you need money?
- How much can you give up now and still meet your life goals?
- What is a reasonable rate of return?
- How much management and expense is there to run the portfolio?
- How much margin of error is required?
- What if I save less now and more later?
Save 10% is a rule of thumb. It is not in any way sacred and you should never believe a rule of thumb suits you specifically. They seldom do.
In our case, suppose the person is a teacher and they have a large pension plan that will pay 70% of their best five years at retirement. Indexed to inflation. They must contribute about 6% of after tax income to get it. Should they save 10% or just the part in excess of the pension contribution?
If on the other hand, the person is a tradesman with their own small business, they will have no pension and the 10% might be too low.
Rules of thumb are gross generalities and cannot be relied upon in specific cases.
Find your strategy (the what do I want, when, questions) and then find a tactic to get the outcome you need.
Life balances. That is one of the fundamental meanings. What you spend now will be unavailable at retirement. What you accumulate for retirement is not available to spend now. Saving too little is a bad thing, but no worse than saving too much.
Decide what you are trying to do and get help with the arithmetic if you need it. If your advisor starts with a rule of thumb instead establishing your strategic needs, find another.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.