If you’re like me, then you like to know why. Words of wisdom don’t really seem as wise when you aren’t clear on the reasoning behind them.
People make up just a whole bunch of crap on the internet.
That’s why today I decided to explain the logic behind an often touted financial truism: you should save 10% of your income for retirement.
The best way to justify this figure is to demonstrate how it works in real life.
The median household income in 2008-2012 was $53,046. Over the course of a career a worker can earn more or less than this amount, but we need a jumping off point.
If someone earning the median income followed the conventional wisdom and saved 10% of every paycheck, they would have $2,850,442.40 when they retired. This assumes that:
- They worked from age 22 to 65 (43 years).
- They got an 8% return on their smartly chosen investments.
- They received a 3% raise at the end of each year. Because they were awesome.
Today almost $3 million sounds like a lot of money. But there is a catch.
In 2012 the average amount of annual expenditures per household was $51,442.
With annual inflation of 3%, this average goes up to $183,365.87 in 43 years when this hypothetical worker is ready for retirement. Which sounds worse than it is.
Assuming that our retiree’s expenses were only 80% of their preretirement spending (a common assumption that I don’t feel like explaining right this red hot second), their savings would last them about 13 years if:
- They reinvested their assets more conservatively (less risk) with a 6% annual return.
- They didn’t invest one penny more.
- They didn’t receive any social security because governments suck at money management.
The average life expectancy is about 79. So hypothetical guy should be good until 78 and then he can crash on a friend’s couch for that last year.
I apologize for the morbidity, but mortality should be a big consideration when financially planing.
What you should take away from this example:
- 10% savings is great, MUCH better than most Americans. 15% would be even better because…
- My stated assumptions aren’t guarantees. You might get 8% and 6% returns on your investments or you might get more or you might get less.
- What if you live to 100 or you plan on spending like Madonna when you retire or you want to leave money to your grandchildren? In all of these cases you’re going to need more cash, so you’ll need to plan accordingly.
- The sooner you start saving and the more you save, the better. The longer and faster your investments grow, the sooner you can afford retire.