Annual Retirement Savings Targets

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

Some of these variables are fairly straightforward.  For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.

Other variables are more challenging to estimate.  For example, I dedicated a whole separate post to the topic of setting your retirement savings target.

Your Risk Tolerance

Your risk tolerance is a measure of how much volatility you are willing to take in your investments.  As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results.  My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.

Here are a few thoughts that might guide you as you figure out your personal risk tolerance.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities, you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

As can be seen, the more risk you take, the higher the average return.  As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.

Taxability of Investment Returns

In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date.  For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic.  If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.

In the previous section, you selected an average annual investment return.  The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.

US – Taxable

Canada – Taxable

All Tax-Deferred & Tax-Free Accounts

Money Market

Multiply by 0.75

Multiply by 0.75

No adjustment

Bonds and Bond Mutual Funds

Multiply by 0.75

Multiply by 0.75

No adjustment

Equity Mutual Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Equities and Index Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Further Refinements to Tax Adjustments

You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the US-Taxable column would be reduced to 0.75.

The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative.  Specifically, if you don’t sell your positions every year and re-invest the proceeds, you will pay taxes less than every year.  By doing so, you reduce the impact of income taxes.  Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.

Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own.  The adjustment factors shown apply to corporate bonds.  The tax rates on interest on government bonds and some municipal bonds are lower.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them.  The table below will help you calculate your overall after-tax investment return.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

0.75

Equity Mutual Funds, Equities, Index Funds

Taxable

0.85 if US; 0.87 if Canada

All

Other than Taxable

1.00

Total

There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column.  These assumptions are the percentages of your retirement savings you will invest in:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the Pre-Tax return column.  You also may need to adjust the multipliers as discussed above.

Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row.  Your weighted average after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

I have created an illustration in the table below.  For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities.  You are able to put 60% of your portfolio in tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient investing, you split your bonds and stocks between account types in the same proportion as the total.  As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities.  The 60% you put in your tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Product

Money Market, Bonds or Bond Mutual Funds

Taxable

20% 3% 0.75

0.5%

Equity Mutual Funds, Equities, Index Funds

Taxable

20% 8% 0.85 if US; 0.87 if Canada

1.4%

All

Other than Taxable

60% 5.5% 1.00

3.3%

Total

5.2%

I’ll use a pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax return for that row is the average of 3% and 8% or 5.5%.

I then calculated the products for each row.  For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75.  The weighted average after-tax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%.  The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

With that information, you can now estimate how much you need to save each year if you don’t have any savings yet.  I’ll talk about adjusting the calculation for any savings you already have below.

I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year.  For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on.  In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.

Annual Savings/Total Target

The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and after-tax annual average investment return.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

17.6% 7.8% 4.6% 3.0% 2.1% 1.6% 1.2% 0.9%

3%

17.3% 7.4% 4.3% 2.8% 1.9% 1.4% 1.0% 0.8%

4%

16.9% 7.1% 4.0% 2.5% 1.7% 1.2% 0.9% 0.6%

5%

16.6% 6.8% 3.7% 2.3% 1.5% 1.0% 0.7%

0.5%

6% 16.3% 6.5% 3.5% 2.1% 1.3% 0.9% 0.6%

0.4%

7% 16.0% 6.2% 3.2% 1.9% 1.2% 0.7% 0.5%

0.3%

8% 15.7% 6.0% 3.0% 1.7% 1.0% 0.6% 0.4%

0.3%

As you can see, the more risk you take, the less you need to save on average.  That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller.  Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage.  I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax investment return and a column that corresponds to your time to retirement.  You multiply this percentage by your total retirement savings target.  The result of that calculation is how much you need to save in your first year of saving.  To find out how much to save in the second year, multiply by 1.03.  Keep multiplying by 1.03 to find out how much to save in each subsequent year.

Earlier in this post, I created an example with a 5.2% after-tax investment return.  5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example.  I have calculated your first- and second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row) Total Retirement Savings Target First-Year Savings Amount Second-Year Savings Amount

5

16.6% $500,000 $83,000 $85,490

15

3.7% 2,000,000 74,000

76,220

30 1.0% 500,000 5,000

5,150

40 0.5% 1,000,000 5,000

5,150

The first-year savings amounts in this table highlight the benefits of starting to save for retirement “early and often.”   It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year.  By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings.  With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.

Adjusting for Savings You Already Have

The calculations above don’t take into account that you might already have started saving for retirement.  If you already have some retirement savings, you can reduce the amount your need to save each year.

The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier.  To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target.  The future value is the amount to which your existing savings will grow by your retirement date.  The formula for future savings is:

where n is the number of years until you retire.  The annual return is the same return you’ve been using in the formulas above.  If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

40

2%

1.10 1.22 1.35 1.49 1.64 1.81 2.00 2.21

3%

1.16 1.34 1.56 1.81 2.09 2.43 2.81 3.26

4%

1.22 1.48 1.80 2.19 2.67 3.24 3.95 4.80
5% 1.28 1.63 2.08 2.65 3.39 4.32 5.52

7.04

6% 1.34 1.79 2.40 3.21 4.29 5.74 7.69

10.29

7% 1.40 1.97 2.76 3.87 5.43 7.61 10.68

14.97

8% 1.47 2.16 3.17 4.66 6.85 10.06 14.79

21.72

Illustration of Adjustment for Existing Savings

Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%.  You would use the factor from the 5% row in the 25 years column of 3.39.  You multiply $50,000 by 3.39 to get $169,500.

If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500.  Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458.  This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.

Caution

Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution.  All of the amounts that I’ve estimated in this post assume that you earn the average return in every year.  There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out.  As mentioned above, riskier assets have more volatility in their returns.  That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.

As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire.  I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations.

 

Savings Framework and Emergency Savings

You may be thinking you’d like to get started with investing.  Before doing that, you’ll want to look at how much savings you have and how much you can invest.  In this three-part post, I’ll illustrate a framework to guide savings and investing decisions.   This post will focus on a very high-level structure for your investable asset portfolio and, specifically, emergency savings.  My next post presenst a case study addressing saving for large purchases and retirement.  The third post will continue with the case study, focusing on when to accelerate your debt payments.

Case Study

To help set the stage, I’ll create a fictitious person, Mary, whose finances I’ll use for illustration.

Mary’s Situation

  • Mary is single with no dependents.
  • She lives alone in an apartment she rents.
  • She makes $62,000 per year.
  • Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
  • Her annual budget shows:
    • Basic living expenses of $40,000
    • $5,000 for fun and discretionary items
    • $10,000 for social security, Federal and state income taxes
    • $4,000 for 401(k) contributions
    • $3,000 for non-retirement savings
  • Mary has $15,000 in student loans which have a 5% interest rate.
  • She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
  • She has no plans to buy a house in the near future.

Mary's-Savings-Infographic

Mary’s Questions

Mary’s questions are:

  • Should I start investing the $25,000 in my savings account?
  • Should I have a separate account to save the $10,000 for the car?
  • What choices do I have for my first investments for any money I don’t set aside for my car?
  • Should I pay off some or all of the principal on my student loans?

Investable Asset Portfolio

Investable asset portfolio? Isn’t that something for companies and for the rich?  Actually, no. I think about any savings and other invested assets as a portfolio.  My husband and I own many other assets, such as our home, our cars and our household goods.  Because those are not assets that we can invest, we include them when we are evaluating our net worth but don’t consider them part of our investable asset portfolio.   Mary’s investable asset portfolio consists of her savings account and her Roth 401(k).

Within my portfolio, I strive to keep a target amount in very liquid (i.e., easily converted to cash), low risk assets for emergency savings.  If I have a large purchase that I want to make soon, such as when we sold our house but knew we were going to buy a new one, I invest that money in slightly less liquid, slightly more risky assets with slightly higher returns.  I’ll call these designated savings and talk about the investment I chose in the next post in this series.  I then look at the rest of my portfolio in terms of how long until I will need the money, how much return do I want and how much risk I can tolerate, as well as how much time I’m willing to spend researching and monitoring it.

Expenses Paid Less than Monthly

There are some expenses that you pay less often than once a month.  Examples include presents (most of us have a relatively large expenditure in December, but also don’t forget birthdays), property taxes if you own a house and insurance.  In the months that you don’t have these expenses, you’ll want to set aside enough money so you make these payments when they are due.

Mary has made a list of these expenses from her budget.  Specifically, she has budgeted $400 for presents, $1,000 for a vacation and $1,000 for car and renters insurance which she pays once a year.   She puts $200 a month into her bank savings account to cover these expenses. When she pays for her insurance or vacation, she transfers the money back to checking.

Emergency Savings

How Much?

Three to six months of basic expenses is considered a good target for emergency savings.  To help me estimate how much I need in emergency savings, I imagine what would happen if I couldn’t work for that time period. There are many expenses that will be eliminated, such as income taxes, commute expenses and some others. However, there are also additional expenses, possibly including the full cost of health insurance.[1]

In addition to not being able to work, other uses of emergency savings include unexpected medical expenses, serious illness or death in your close family that requires travel and major repairs to your car or house.  It is important to recognize what is an emergency and what is not.  For example, a funeral is an emergency, while a wedding is a luxury.  Your furnace needing replacement is an emergency.  Routine maintenance and even medium-sized repairs to your car or house are not emergencies as they are budget items.  An important component of using emergency savings is to modify your budget immediately to start re-building it.

Mary has decided to start with a target of four months of expenses for her emergency savings and plans to build it up using $1,500 a year from her non-retirement savings budget until it reaches six months of expenses.  As a first approximation of how much emergency savings Mary needs, she could take a third (four months divided by twelve months in a year) of her salary or just over $20,000.  Because Mary has a budget, she can identify those expenses that absolutely necessary. Her budget shows $40,000 of basic living expenses so a third of that would be $13,333.  She will use $13,000 as her target for her emergency savings, leaving her with $12,000 for designated and long-term savings.

Where to Invest?

Mary considers only a few choices for her emergency savings – including her bank savings accounts, a high-yield checking or savings account at a brokerage firm and a money market account.

A Bit about Money Market Accounts

Money market accounts tend to return a slightly higher yield than savings accounts.  They are like other securities in that you have to buy and sell them, but you can often have access to your money in 24 hours (as compared to instantly for a savings account).

Money market accounts also have slightly more risk than savings accounts. Many money market funds buy very safe securities, such as certificates of deposit and US government bonds so have very little risk.  Others take more risk by investing in commercial paper which is essentially a short-term loan for a company.  In 2008, the value of a few money market funds backed by commercial paper fell below $1.00.  When the value of a money market fund falls below $1.00, it is called “breaking the dollar,” For emergency savings, you’ll want to focus on funds backed by US government debt securities.

Money market accounts from a bank are insured by the Federal Deposit Insurance Corporation, while those at brokerage firms are not.  Money market funds at brokerage houses are insured by the US Treasury if the brokerage firm fails but not if the fund breaks the dollar.  If the value of the investments purchased by the money market fund fall in value, the value of your principal might decrease.  I am not aware of any money market funds that have lost value.  There are some money market funds that invest in higher risk instruments.  For emergency savings, Mary will consider only money market funds that buy low-risk instruments.

You might be thinking I’m kidding.  Keep some money in a savings account!  You might be excited to participate in the seemingly glamourous world of trading stocks and other financial instruments.  Unfortunately, those financial instruments are risky.  That is, you might lose some of the money you invest in those instruments if their value goes down.  (I have a lot to say about risk and reward in this post.)

Back to Mary’s Emergency Savings

Because emergency savings are meant to be available on a moment’s notice at their full value, Mary will keep hers in those two very boring places – a savings account and a money market account.

At one brokerage firm, high-yield checking and savings accounts are earning 0.35% to 0.45% as I write this post.  US government-backed money market accounts are earning as much as 1.9%[2]or about 1.5 percentage points higher than the checking and savings accounts.  (The money market rate at one bank is 1.87%[3]or essentially the same as the brokerage firm.) Mary decides to put half of her emergency savings in a high-yield checking account so she is sure to have instant access to it and half in a money market account.  This decision gives her an average return of 1.275%, as compared to the 0.06%[4]she was earning on her bank’s savings account. So, while the savings account and a money market account are not as exciting as buying stocks, she can improve her return as compared to her bank’s savings account.

In the next post in this series, I’ll talk about how Mary plans to invest her designated savings and long-term savings.  I promise – the choices get a bit less boring.

Key Points

The key takeaways from this case study are:

  • There are different purposes for savings – expenses you don’t pay every month, emergencies, large future purchases and long-term.
  • Expenses paid less than monthly can be budgeted and set aside in a very safe, easily accessed place, such as a savings account, until needed.
  • Emergency savings of three to six months of basic living expenses is a good target.If you have lots of back-up options – financially supportive parents or relatives, another place nearby you could live for a few months in an emergency or the like, your target can be at the low end of the range.   On the other hand, if you are like one friend of mine whose family lives in Europe while he lives in the US so an emergency trip home would be very expensive or you don’t have many back-up options, you might want to set the high end of the range as your ultimate target.
  • It is important to replace emergency savings as quickly as possible after using them.
  • A portion of emergency savings (the greater of one month’s expenses or travel expenses to immediate family) should be available at any time; while a portion can be invested in something that takes a day or two to access.

Your Next Steps

This post talks about Mary’s situation.  Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.

  • Make a budget. A budget will help you understand your financial situations. For help with budgeting, check out my series of posts with a step-by-step plan for building a budget, starting with this one<//li>.
  • Identify the expenses in your budget that you pay less than once a month. Determine how much you need to set aside each month to cover them.  In each month, you will increase this component of your savings by 1/12thof the total amount of less-than-monthly expense.  You will also reduce it by any of these expenses that need to be paid in the month.
  • Do you want to start a relationship with a brokerage firm? If so, here are some questions to consider:
    • What types of accounts does it offer?
    • What are the fees and limitations associated with those accounts?
    • What are the returns it is offering on those accounts?
    • Can you access those accounts using an ATM card, electronic banking or checks? What are the fees associated with them?  My brokerage firm waives all ATM card fees which is great in an emergency because I can get cash anywhere in the world.
    • Do you want to be able to meet with someone in person? This question was critical for me.  While I probably use e-mail more than I should, I need to be able to go into the office for big transactions and, to a lesser extent, advice.  If you are like me in that regard, particularly if you are looking for advice, you’ll want a brokerage firm with a conveniently-located office and a team you can trust.
  • Set an emergency savings target.
  • Look into options for your emergency savings.
    • Does your bank or, if you have one, brokerage firm, offer high-yield checking or savings accounts? What are the fees and limitations on those accounts? An account with a large minimum balance isn’t attractive for emergency savings because you might need to empty it on short notice.
    • Do you want to consider a money market account for some of your emergency savings? If so, what options are offered by your bank and brokerage firm? What returns are being offered? How long will it take to access your money? How easy is it to access the money, such as by transferring it to your checking account? In an emergency, you probably won’t want to feel overwhelmed by the process of accessing your emergency funds.

  • [1]For a longer discussion of emergency savings, check out http://brokewallet.com/emergency-fund/.

    [2]https://www.schwab.com/public/schwab/investing/accounts_products/investment/money_markets_funds/purchased_money_funds#government_treasury, December 2, 2018.

    [3]https://www.wellsfargo.com/investing/cash-sweep/rates-and-yields/, November 29, 2018.

    [4]https://www.wellsfargo.com/savings-cds/rates, November 17, 2018.