The Default Settings on Your Retirement Plan and How to Utilize It (Part One)
Today’s retirement isn’t your grandfather's retirement. Things have changed a lot over the last 30 years. There are less pensions than ever, and more companies are moving to 401(K) types of retirement plan over the old pension plan because they are cheaper and easier to manage. They are also incentivized by the government to do so by deducting it from their taxes. In fact, the US government has a default plan for everyone, it’s just a matter of if you follow it, and more importantly, knowing how to utilize it.
The first step is to look at retirement expenses, as they are typically less than when you are working. Less commuting, not putting money towards retirement, lowering health insurance costs, and lowering taxes all drop your expenses by about 15% on average. So, in retirement you need to replace about 85% of your working income, and the government helps you out with that by providing social security. Social security is designed to replace about 35% of your working income at full retirement age (67). This leaves us to replace the remaining 50% of working income through our retirement plans like a 401(K) or IRAs.
How does this replace your working income? And more importantly, how do I replace 50% of your income without running out of money? This is where the rule of 4%, or the stable withdraw rate, comes into play. The percentage can change depending on who you talk to, but for this exercise we will stick with 4%. Therefor a simple math problem can give you a rough estimate of your retirement number right now. Take half of your annual salary and divide that number by .04 or 4%. Let’s use $100,000 for our salary. Half of that is $50,000 and dividing that by 4% gives us a ballpark estimate of $1,250,000 needed for retirement. Another way of looking at this is you need about 12.5 times your annual salary to retire.
The final step of this default plan is to save about 10% of your income and invest it. The assumed rate is around 7%, which with constant contributions, will double every ten or so years. The thing about compounding interest is that it grows exponentially. If we follow this saving plan, and invest in relatively safe investments, we should see about 1 times salary saved up by age 30. We then see it double over ten years to being 2x salary at age 40, then 4x by age 50, and 8x at age 60. Then we reach our mid 60s when we are Medicare eligible, and social security eligible, and we should have 12.5x salary saved up.
This is what is laid out as the default retirement plan for most Americans born after 1960. There are outside factors that can affect this plan that you have no control over, such as a recession, job loss, or disability, but this is pretty much the average retirement plan in America. There are ways to exploit this system though to retire earlier than your mid-60s, and I plan on going over that in part two of this article. If you would like to learn more about how you can improve your retirement plan, you can always set up a call with me using this link. Thanks for reading!