Sometimes I think investment advisors are setting us up to fail. I recently read a newsletter from one of the major investment advisement firms, and here’s the advice I took away from it: a person making $100,000 should save $10,000 per year and should also expect to spend $90,000 in retirement. This 90/10 split is a ratio I see over and over – it’s not just this one firm. But sound as it may seem to them, I believe this is terrible advice. An outlook like this burns our dollar bill at both ends, vastly underestimating our ideal savings rate and greatly inflating what we should expect to spend in retirement.
To understand why, let’s use the generally agreed upon assumption that a person can withdraw 4% yearly from their portfolio and not go broke over a thirty year retirement. At this withdrawal rate, we need to build up a $2.2M nest egg to expect a safe retirement of $90,000 per year spending. If we save $10,000 every year over a 40-year career, and achieve a yearly investment return of 8%, then we would achieve this goal, with a little bit of room to spare.
But what’s wrong with this picture? Well, it doesn’t account for layoffs or family emergencies. It assumes a very steady (and steadily increasing) income, which the average family simply cannot count on. In short, it’s a plan that doesn’t account for the messiness of real life. If we miss even a few years of investments, or have to raid an account or two to survive a rough patch, we would see our retirement date move further and further into the future.
Funding retirement like this is a moonshot. Like so much financial advice I read, it is well intentioned but, in practice, completely implausible for the average family. And perversely, I think it gives the average person too many excuses for not saving. Like walk-on golfers randomly paired against Tiger Woods, they feel little shame at losing, because they never believed that their game was winnable.
However, if we made just two small adjustments to our ratio, we’d be on much firmer footing. Let’s increase our savings rate to 20% per year (or $20,000), knowing that we may not succeed every year. At the same time, let’s plan to spend only 80% (or $80,000) in retirement. At our safe withdrawal rate of 4%, we’ll need $2M saved up, not much less than before. But if we invest $20,000 per year over a 40 year career, we could amass over $5M using the same rate of return. This is more than double what we actually need. Now, we don’t actually expect to hit this number; countless life events will divert us form our 20% goal. But with a cushion this big, we can survive a health emergency or a layoff. We can accept smaller than average investment returns. And we can still retire on time.
The great news is that we don’t need a $100,000 salary to make this work, because the ratio of saving to spending matters more than the dollar figure. If we can save 20% of our salaries and can plan to spend 80% (or less!) in retirement, we have a very high chance of making our retirement goals a reality. What about 75/25? We’d be even better off, and might retire earlier than expected. The point is that we can choose where we want to fall on this spectrum and make decisions to reach our goal. We may have to sacrifice a bit up front. But at least we’re not set up to fail.