Employers, employees, and reporters often ask me a basic question: “How much do I need to save in order to prepare for retirement?”
On average, employees need to save at least 10% of their pay year in and year out to effectively accumulate enough money to create a paycheck for life. More importantly, your employees need to calculate how much of their income they need to replace in retirement to successfully create that paycheck for life. In our experience, most employees don’t know how to do this or don’t spend the time to do so, which is unfortunate because it’s such an important number.
How is this calculated? We have a technical word for it called the “income replacement ratio,” or the “income replacement formula.” Every employee should know this, and every plan sponsor should know this for their employees. Here’s how it works:
On average, at retirement age, your employees probably won’t need 100% of their income. Instead, they’re likely to only need 70%, 80%, or 90% of it. Why? They’re typically saving some of that paycheck, and they likely won’t pay as much in taxes when they retire.
Let’s imagine that you’re 40 years old, your annual income is $50,000, and you decide you want to retire at age 66 and start collecting that paycheck for life. We’ll also assume that social security will make up for a portion of that income replacement. If you only need 80% of your income, that equates to $40,000. That’s $40,000 in today’s dollars, but complicating matters is this little problem called inflation.
The economic definition of inflation, in layman’s terms, is too much money chasing too few goods. Inflation erodes your purchasing power over the years, so you need your income and your savings growing to adjust for a higher cost of living.
This is where what’s called the “Rule of 72” comes into play. The Rule of 72 is a shortcut to figuring out how fast your money will be eroded by inflation. The Rule of 72 helps you figure out how long until your income erodes in half.
As an example, if inflation rates are at 3%, you’ll take the number 72 and divide it by 3, giving you 24. Therefore, it would take 24 years for $50,000 of purchasing power to erode to $25,000.
Let’s look at a real world example of this and turn this calculation around under the same assumption of working until age 66 with an annual income of $50,000. Replacing 80% of that $50,000 would equate to $40,000 per year. However, in 24 years, that $40,000 will only be worth $20,000 in terms of purchasing power. That means you would actually need $80,000 just to keep pace with inflation when you retire.
If you’re thinking this sounds too complicated or you’re wondering how your employees will calculate this, I have good news. Most 401(k) record keepers have calculators that will help your employees calculate their income replacement ratio and the effects of inflation. As a matter of fact, there are even some record keepers who calculate a monthly income for each participant at retirement age.
For example, if somebody needs $2,000 a month to live on and they have only $1,300 projected, the calculator will notify them that they’re short $700 per month and inform them how much additional money they would need to save at a reasonable rate of return and a 3% inflation rate in order to create that paycheck for life.
If you’d like a list of the record keepers that actually do those calculations or convert the lump sum amount that they’ve saved into a monthly amount, email me at email@example.com
What we’re covering here is very important. If your employees don’t know their retirement bullseye, which is how much income they need to replace, what inflation will do to their paycheck over time, and what they need to save as a percentage of their wages, they likely won’t have enough money in their retirement account to create that paycheck for life.
In addition to the record keepers’ calculations, we can create something called a “gap statement” for each employee. The gap statement simply performs the retirement bullseye calculation for them. As a matter of fact, with all our plans, we create a gap statement for all their employees. If you’d like a copy of an example of our gap statement, feel free to email me again at the aforementioned address.
If you’re interested in learning more about my process or the strategies for creating your optimal retirement plan, click here and I’ll send you a free copy of my book “The Retirement Bullseye.”
If you have any other questions about this topic or you’d like to connect with me, don’t hesitate to send me an email. I look forward to helping you.