Sunday, July 21, 2013
What percentage of my income do I need to save for retirement?
In the past, retirement income came from three sources; government social security, company pension, and personal savings - the three legs supporting the stool. But now most young people do not work for a company with a pension plan and they do not trust social security to be around for them. The stool now has only one leg - personal savings.
A young person today will work for about 40 years (age 25 to 65) and perhaps live another 30 years (to age 95).
So what percentage of annual income does this young person have to save for retirement? Roughly 50%. What, you say? My financial advisor says 10%. How do you get to 50%?
I was born in 1939. Since 1939, the annual average yield on the U.S. Government long-term security was 5.47%. Subtract 25% for income taxes and you have 4.10%. The average annual inflation rate was 3.91% leaving a real, after-tax return of 0.19% - after taxes and inflation basically nothing at all.
But 1939 was a long time ago. Consider 2011-2012. The average annual yield on the 30 year U.S. Government security was 3.41%. Subtract 25% for income taxes and you have 2.56%. The average annual inflation rate was 2.35%, leaving a real, after-tax return of 0.21% - still basically nothing at all. (And that 3.41% average annual yield sure looks good compared to the 0.01% Chase paid me on my checking account balances in 2011-2012.)
So if you want to have $1 after you retire, you better save that $1 while you are working. In cash - money you can spend at the grocery store - not in home equity.
But how can money have no time-value? How can a dollar saved and invested at age 25 be worth only a dollar after inflation and taxes at age 65? Strange, isn't it? But why should a dollar saved and invested at age 25 be worth more than an inflation-adjusted dollar at age 65? They just electronically create dollars, don't they?
Seventy years ago, a single dip ice cream cone was five cents. Now it is $3.00. An average inflation rate of 6%. Save most of your money. Hard times are coming.