I hate to admit this. I really do. But even though I’m a professional financial planner I didn’t even think to ask myself “ How much money should I save ” until ten years ago. I just saved everything I possibly could.
I didn’t grow up in poverty but my family really struggled financially while I was growing up. As a result, it became my mission to save as much money as I could once I started my career. As a result, I went a little overboard and didn’t get to enjoy life as much as I could have. I spent too much time in financial fear unnecessarily.
Other people have the exact opposite problem. Like me, they don’t ask themselves how much they should be saving. But at as a result they spend too much money and forfeit their financial freedom over the long run. Where is the balance? How do you know how much you should save? My experience tells me that you can find that balance by going through the following five steps:
In order to put saving money in proper perspective, you must first do some soul searching. What are your goals? When do you want to achieve them? How much is it going to cost to reach those goals? Your goals must be defined and crystal clear.
- How much?
2. Calculate Your Target
Let’s assume that your goal is to have enough money to retire. Assume that you calculate (after inflation and tax) that you will need $75,000 a year to live on when you retire 20 years from now. Let’s you’ll have $40,000 in pension and Social Security income once you retire. That means you’re going to be $35,000 short of the mark. We need to figure out how much of a nest egg is required in order to generate $35,000 a year.
You do that by first assuming a certain retirement withdrawal rate. For our example, we’ll use 4%. In other words, we need to figure out how much we need to invest in order to generate $35,000 a year assuming we can withdraw (not necessarily earn) 4%.
The math for this is pretty straight forward. Simply take $35,000 and divide it by 4%. If you do this yourself you’ll find the answer is $875,000. Now we’ve got our target…..almost.
3. Grow to Your Target
We know you are going to need a nest egg of $875,000 when you retire in 20 years. For our illustration, let’s assume you haven’t saved a dime yet so you have to get the $875,000 goal starting at zero. Now we can calculate how much you need to save starting now.
Before we get to the bottom line you have to make an assumption about how much you’ll earn, on average over the next 20 years on your investments and savings.
If you invest your money in a balanced fund for growth and safety for example, you might assume you’ll earn 5% on average over the next 20 years. These funds have not earned that much over the last 12 years but they have earned far more than that over the long-run. In fact, 5% is actually a very conservative estimate. Having said that , keep in mind that in any one year a balanced fund could return significantly less.
Now you know how much you want, when you want it and you have an assumed rate of return. You can use this calculator to plug in the information you have to determine how much you need to save in order to reach your goal. In our case, the answer is a bit more than $2100 a month.
5. What if the required savings is too high?
Sometime the number will be too high. For example, the result of this calculation is that you’ll need to save $2,100. What if you can only save $1,000 each month? Then what do you do?
I think you already know the answer. You have to go back over your plan. You have to change the things you can and accept the things you can’t change. While you could invest more aggressively in the hopes of getting a higher return I don’t recommend this. Such an approach will add more risk. At some point, usually the worst time possible, you’ll likely have an emotional response to the risk and make a very bad decision. The best possible solution is to:
- Recalculate your future cost of living by cutting your standard of living or planning on working during retirement.
- Increase savings by getting a part-time job now.
- Some combination of the two.
If you want to know how much you should save, first be clear on your goal and when you want to achieve it. Then put a price tag on it. Next, identify if your current resources are sufficient (including your Social Security and Pensions) or if not, what the short fall is.
If there is a short fall use an online calculator to work backwards to see what your monthly investments should be in order to reach your goal. If the required monthly savings is too great, reexamine your spending to see if you can make cuts and recalculate the needed savings. If that doesn’t work, think about getting a second job.
My experience tells me that the biggest problem is that people get emotional and intimidated when it comes to calculations like these. As a result, they ignore the subject completely and simply “hope for the best”. What is your experience? Have you sharpened your pencil to determine how much you should save? Have you reached your goal? If not, what did you do about it?
Great article on how to save for retirement! People can use your methods to save for other important life goals as well, but if they are saving money for the short term, I’d recommend a simple savings account – isn’t worth the risk! Thanks for a great article!
Neal Frankle says
John, coming from you , this is a great compliment. Thank you. And I agree – short goals require liquid investments like savings accounts. The return OF the money is far more important than the return ON the money always. And when you have a short term goal, you take too much risk if you invest in anything other than the bank.