Life-stage Investing for Retirement

Retirement Planning Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

Life-stage Investing for Retirement
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
June 8, 2006

How much money do you need to retire? How and when should you start saving and investing for retirement? And what about after you retire? How should your investment plan change as you go from accumulation mode to distribution mode, and how should you spend that money?

All of these are issues we've tackled in separate articles, which are accessible on the Retirement Page. Here, we've summarized some of the main points of those and combined them into a life-stage roadmap for retirement. While no two investors' retirement plans are identical, there are some general principles that can guide you through to retirement. More than anything, putting a plan in place (and sticking to it) is the key to reaching your goal.

Establishing a plan
Before you can begin planning your retirement portfolio, the first step is to determine just how much money you'll need to retire on. While this amount differs for everybody, a good goal is to figure on replacing 100% of your pre-retirement annual income during the first year of retirement—less whatever you were saving for retirement, of course. For example, if you're making $75,000 and saving 20% ($15,000), then you should figure on needing $60,000 to maintain your lifestyle (some expenses may go away, such as commuting costs, but others could take their place, such as increased travel and health care).

In Spending Confidently in Retirement , we looked at what size portfolio you might need to be highly confident of maintaining your standard of living over a 30-year retirement. We recommended shooting for a portfolio roughly 25 times the amount you plan to spend in your first year of retirement, minus what you expected from other sources of income such as Social Security. This translates into a withdrawal rate of roughly 4 percent of the portfolio's value in the first year of retirement, which is then grown for inflation over the rest of the retirement time horizon.

That doesn't mean you withdraw 4% of your portfolio's value each year. The key is to strike a balance between not running out of money prematurely AND maintaining a reliable standard of living, adjusted for inflation, from one year to the next. Based on thousands of simulations, a 4% first-year withdrawal rate should allow you to grow that dollar amount for inflation each year with about a 90% probability you'll have $0 left at the end of 30 years.

For example, extending the example above, if you expect $20,000 from Social Security, then you would need $40,000 from your portfolio in the first year of retirement to make up the difference. If you're a conservative-to-moderate investor and want a high probability you can keep up with inflation over 30 years of retirement, you should plan for a $1 million retirement portfolio (25 x $40,000 = $1 million).

As with any general guideline, your personal circumstances will dictate what's best for you. You may want an even higher confidence level, which means spending less in retirement and/or planning for a bigger portfolio. On the other hand, you may be willing to settle for a lower probability that your retirement portfolio will last 30 years, which means you could spend more and/or accumulate less.

Let's assume you like the idea of having a high probability of maintaining your lifestyle over a 30-year retirement. What percentage of your pre-tax salary¹ should you be saving now to give yourself a good chance of achieving that goal?

First, let's assume you plan to retire at age 65 and have no previous retirement savings—you're starting from zero. If you already have retirement savings (and you're a Schwab client), you can log in and use the Schwab Retirement Planner to run your own numbers. Let's also assume you have a conservative-to-moderate portfolio allocation in retirement (with no intent to leave a portion of the portfolio to any heirs), and that your average compound annual return is 8% on your pre-retirement investments, with 2.5% inflation.

Given these assumptions, here are some broad guidelines for the percentage of your salary you should be saving each year for retirement. These are minimum targets—if you can save more to increase your probability of success, all the better.

Saving for retirement

Age when saving starts	% of salary to save each year
20-something	10%-15%
30-something	15%-25%
Early 40s²	25%-35%

Once you start, the same savings goal applies until you retire. In other words, if you start saving roughly 12% of your income in your mid-20s and have the discipline to maintain your savings plan, you shouldn't have to increase that percentage as you go through your 30s, 40s and so on (the dollar amount you save will grow with your salary over time). That's the benefit of getting an early start saving for retirement.

Now, let's look at ways to make sure your plan stays on course, and maybe improve upon it a little during the various stages of your life.

The early days
If you're still in your 20s, you have a great opportunity to lock in a low savings percentage. Do what you can to get used to living on a little less now—it will be a lot harder later on. Failing to save enough results in a double-whammy—you become addicted to spending more, but have even less in the way of a retirement portfolio to fund the lifestyle you've grown accustomed to. So, beginning with your first job out of school, consider setting your 401(k) contribution to at least 10%-15%. Convince yourself that your retirement funds are untouchable. Yes, it takes discipline, but worthwhile goals are seldom easy.

Once you're in your 30s, building the retirement nest egg will be a little tougher if you didn't start earlier, but it's still very doable. Track your spending. Do you really need to spend $3 per day on a double mocha latte? Could you live without the expensive SUV (especially with today's high gas prices)? Take full advantage of your employer's 401(k) or other retirement plan, at least up to the point of any matching contribution. Consider the benefits of contributing to a traditional IRA or Roth IRA, if you're eligible. Next time you get a bonus, try to put most or all of it into your retirement savings.

Middle life
Once you're in your early 40s, you should have a good start on your retirement savings. If that's the case, just make sure to stick with it. If you haven't yet started, there's still time to establish a significant base of retirement savings, although you may have to settle on somewhat lower spending habits once you reach retirement (and/or postpone your retirement date a bit). Your main goal should be to max out your 401(k) or other employer retirement plan. Add an IRA or a Roth IRA if you're eligible. If you work for yourself, take advantage of a self-employed retirement plan such as an Individual 401(k) SEP-IRA or QRP/Keogh plan. If you can still put away more, save and invest the rest in your regular brokerage account. If college for your children is looming, consider ways to deal with that financial burden without sacrificing your own retirement security. See The Parent Trap: College vs. Retirement for more about college savings.

As you near retirement, your savings plan should be firmly in place. If it's still coming up short, there are ways to supplement it. If you're 50 or older, take advantage of any additional "catch-up" contributions available to you through your employer's 401(k) plan or your IRA.

And remember, our savings targets assume you will retire on roughly the same level of income as your pre-retirement, pre-tax salary (less what you were saving for retirement, of course). You might be able to get by with less than that. You also might postpone retirement for a few years. By retiring later, you can build a bigger retirement portfolio and shorten the amount of time you'll need to sustain retirement spending. You can also increase your potential Social Security benefit by waiting past the "normal" retirement age before you start receiving payments (up to age 70). For example, if you are able to start saving 25% of your salary at age 45 and maintain that percentage (adjusted for inflation), then you should have a good chance of reaching your goal by age 68 or 69.

In retirement
The key to a comfortable retirement is managing your cash flow. How much are you likely to spend in retirement? Where will you live? Will you still have a mortgage or pay rent? How much will medical insurance cost? How long do you expect to live? Do you want to provide for heirs or charities?

These questions can help you determine your cash flow needs. You'll also need to factor in any other fixed expenses, inflation, taxes, and whether you'll have sources of income other than your portfolio.

How might you increase your chances of not running out of money?

Spend less in retirement. Besides providing the most bang for the buck, changing your level of spending may be the most practical way to increase confidence.
Work part-time. You could also semi-retire and supplement your retirement income by working part-time at something you enjoy. This could be especially attractive if you want to remain active and productive.
Save more. Retiring with a larger portfolio also raises the confidence level. This could mean saving more earlier on or postponing retirement for a few years.
Increase your potential return by taking on more risk. While appropriate for younger investors still in the early stages of retirement saving, taking on more risk could have a diminishing impact later on the ability of the portfolio to sustain cash flows past a certain point, because the expectations for higher volatility tend to undermine the benefits of higher potential return.

These choices aren't mutually exclusive. What's more, though guidelines like these make planning easier, life doesn't always go according to plan. If a bear market hits during retirement, for example, you may want to lower your spending based on the performance of your portfolio.

Stay flexible
General guidelines are all well and good. But if you're truly concerned about your ability to achieve the retirement of your dreams (and you should be), you should analyze your particular situation in more detail to figure out what makes the most sense for you. Get some help if you need it and revisit your plan regularly to make sure you're on track.

It may not be easy, but retiring with peace of mind is worth the effort.

1. We use pre-tax salary for three reasons:

Pre-tax salary is a familiar benchmark. For example, if you're earning $75,000 per year and that's enough to cover all your expenses plus taxes—even after you save 20% off the top—you might figure you can maintain your lifestyle in retirement on pre-tax income of $60,000 (adjusted for inflation).
The bulk of your retirement income will likely be withdrawals from tax-deferred accounts, which are subject to ordinary income tax. So, a projection based on pre-tax income before and after retirement is an apples-to-apples comparison for the most part. To the extent you're in a lower tax bracket in retirement and/or withdrawals come from a Roth IRA or long-term capital gains in taxable accounts, you'll be that much further ahead after taxes.
Employees typically select a percentage of their pre-tax salary to contribute to a 401(k) or other qualified employer retirement account—which makes a pre-tax savings goal easier to achieve.

You can always perform a more detailed, after-tax, line-item budget analysis and projection if you like.

2. For people 40 or older who have not yet started to save, the retirement spending goal is 70% of pre-retirement, pre-tax income—a higher level would require an unreasonable percentage of current savings.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. Investors should consult their own tax and investment advisors about their specific situation prior to taking action based on this article. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

(0606-6298)

Return to Top

On track for retirement?

Find out with our Retirement Savings Calculator.