Creating a Target Savings Rate

     Most adults between the ages of 25 – 50 years old don’t have a good idea of how much annual income they will need when they retire.  It is not until about five years or so from retirement that they start to have a pretty good grasp on how much money they expect to need in annual income to support their current quality of life.  Unfortunately though, their savings may not be enough to fund that lifestyle that they wish for, or are accustomed to.  With only a few short years left before their anticipated retirement date, a significant lifestyle change in order to save more money will likely be too stressful to successfully accomplish.  After all, “you can’t teach an old dog new tricks.”

     Here is how you can calculate a savings goal for retirement.

     For the example below, Mark and Mandy are both 42 years old currently, with an annual household income of $100,000, and are planning to retire at age 67.  Combined, they have saved $150,000 in their qualified 401(k) retirement savings plans at work.  They would like to know how much they should save every year, and if they are on-track to achieve their goal.

     First, Mark and Mandy estimate how much income they would like to have in retirement.  (To do this think of it in terms of today.  If your goal/plan is to retire at age 67, then imagine you are now 66 and planning to retire next year.  What annual income do you think you would need to support your retirement?  Be realistic in your assumption.  If your current household income is $100,000 annually, I wouldn’t recommend assuming that you will have no debts and would do just fine with $45,000.)  Mark and Mandy feel like they would be comfortable retiring on 80% of their current annual income.  Since their current household income is $100,000, that would be equal to $80,000. ($100,000 x .8 = $80,000)  If it turns out later that they will not need 80% of their current income in retirement, their chance of successfully funding their retirement would increase.

     Now that they have their annual income goal in today's dollars, they will use it to determine an equivalent value in the future.  Meaning, if they need $80,000 today, what is an equal amount 25 years from now?  If we had no inflation for the next 25 years then $80,000 today would have the same buying power 25 years from now.  However, they know that is highly unlikely.  Historically, we have had an average annual inflation rate of about 3.25% annually.  To calculate what the buying power of $80,000 today would be in 25 years, assuming a 3.25% annual inflation rate they would use the equation:

FV = PV x (1 + r)^t   (Ex:  80,000 x (1+0.0325)^25

  • FV = Future Value (what we are solving for)

  • PV = Present Value (in this case, it is a PV income goal of $80,000)

  • r = Interest Rate (we are assuming an annual inflation rate of 3.25%, which is equal to 0.0325)

  • t = Time (we are using 25 years in our example)

     Any scientific calculator can do this equation.  If you have a Windows 10 computer, you can open the calculator app and change it to Scientific mode by clicking on the three horizontal bars in the top left. (under the word “Calculator”)  Alternatively, you can use the online calculator at http://www.financeformulas.net/Future_Value.html  (Scroll down to the bottom of the page to find the calculator.)

     At this point they have estimated that $80,000 today, will have the same buying power as about $178,000 in 25 years.  Therefore, that is their income goal in retirement.  The next step is to determine how much money they will need to have saved by retirement, in order to withdraw $178,000 per year for their expected retirement timeframe of 20 years.

     Simply multiplying $178,000 by 20 (=$3,560,000) would give them a number that is much too large because they wouldn’t be taking into account any growth that would likely occur on the money throughout their retirement.  Mark and Mandy estimate that once they retire, their assets will achieve an annual growth rate of 6% over the 20 years.  Therefore, they use the equation

     This formula is known as the “Present Value of an Annuity.”  It answers the question, “If I want to receive ‘P’ amount of dollars for ‘n’ periods/years, and I achieve a return of ‘r’ throughout the period, how much money do I need to start with, in order to finish with $0.00?”  There is plenty of information on the internet about how to calculate this number, but the online calculator at:  http://www.financeformulas.net/Present_Value_of_Annuity.html (scroll to the bottom of the page for the calculator) is very simple and straightforward.

     To meet their estimated goals, Mark and Mandy determine that they will need approximately $2,041,646 when they retire at age 67.

     Now that they know how much they will need 25 years from now the question becomes, how much will they need to save every year in order to meet their goal?  Since they believe that they will achieve a 7.5% annual investment return until retirement, they can determine how much they will need to save per year.

     To do so, they will first calculate how much their current $150,000 savings will grow to over the next 25 years.  For this, they use the same future value formula (or calculator) from above, FV = PV x (1 + r)^t .

FV = 150,000 x (1 + 0.075)^25 = $914,751

     Next, they can subtract $914,751 from their total goal of $2,041,646 because that money is already in savings and expected to achieve their growth expectations.  Therefore, the new target savings goal is $1,126,895 over 25 years.

To solve for the annual savings amount going forward, they would use the formula:

     The online calculator for this formula is located at http://www.financeformulas.net/Annuity-Payment-from-Future-Value.html  (scroll to the bottom of the page for the calculator)

     Mark and Mandy have estimated that if they save about $16,577 each year, they should meet their retirement income goal of $178,000 per year in 25 years.  They also realize that if they both contribute 15% to their 401(k) retirement plan at work, that would be $15,000 per year. ($100,000 * 0.15 = $15,000)  They would only need to save an additional $1,577 per year, or $132 per month, to reach their goal.  With a little planning and discipline, this is an attainable goal that should not impede on their standards of living.

     Since Mark and Mandy had saved $150,000 along the way, they have a high probability of achieving their retirement goal.  Had they not saved any money and were starting at $0, their target annual savings goal would be just over $30,000!  At 42 years old, the $150,000 that they have today is the foundation for their path to success.  Without it, their annual savings requirement almost doubled and would have gone from a high probability of success, to a practically unachievable dream.

 

Kevin Warman

(Last Updated 1/14/2017)