Overview
Saving for retirement is the one worry almost every working adult has unless of course he or she is already wealthy. We all think about at one time or another, “How much do I need to save for retirement?” This often depends on expected lifestyle in retirement and sources of retirement income such as social security, investments, or part-time jobs versus expected expenses. However, equally important questions are “How much will I really save for retirement in my 401(k)?” and “How much will I have for retirement in my 401(k)?” These are difficult questions to answer, as it is highly dependent on ones current and future earning power and savings rate. For instance a physician may earn more than an engineer who in turn earns more than a secretary. The direct consequence is that the physician should be able to save more for retirement than an engineer or secretary. But sometimes that is not the case. Life circumstances also play a role but these are difficult to model since they are often singularities meaning that a loss of a job or health problems are periodic events and are often not foreseeable.
However, it is possible to examine how much one will save in their retirement savings plan through basic assumptions and modeling in order to establish an investment plan. This is not a new exercise for most workers who often use various websites to calculate future retirement account values. But often the assumptions are overly simplistic leading to unreasonable values. In this article I present an MS Excel analysis of retirement savings answering the two aforesaid questions highlighted in bold demonstrating that it is possible to save enough to be financially comfortable in retirement even starting at an age of 30 or 40.
Savings For Retirement
Source: fool.com
Wealthy or Financially Comfortable In Retirement?
In the U.S., the dollar value to be considered wealthy varies depending on ones' location. A recent survey by Charles Schwab (SCHW) indicated that to be considered wealthy one needs $1.8M in Charlotte, NC but the number increases considerably to $3.2M in NYC and $4.2M in the San Francisco Bay Area, CA, as seen in the chart below. These dollar values are probably unattainable for most people through retirement saving plans alone. However, the survey also indicated lower dollar values needed to be financially comfortable, which we will use as target values for retirements savings despite Ms. Suze Orman’s contention that one needs $5M or more to retire. These values are much more attainable through workplace retirement savings plans. In Charlotte, NC and Denver, CO one needs $540k while in NYC and the San Francisco Bay Area, CA one needs $1.1M to be financially confortable.
How Much Does It Take To Be Wealthy Or Financially Comfortable?
Source: aboutschwab.com
How Much Will I Really Save For Retirement In My 401(k)?
This is a difficult question and often depends on life circumstances. A young person who enters the work force often has student debt, perhaps a few thousand dollars in credit card bills, possibly a car loan, and rent payments. If one gets married there is the added costs of starting a household and saving for a house down payment. In any case, we make the following assumptions for modeling a 401(k) retirement plan:
- Saving for 25 years or 30 years,
- Start saving (contributing) at 6% of annual salary,
- A 0.25% increase in annual savings rate up to 10%,
- Company match of 100% up to 3% of annual salary, and
- A 3% salary increase per year.
I view these assumptions as conservative. If one started saving seriously for retirement between the ages of 30 and 40 then a 25-year or 30-year period is achievable. Most 401(k) plans allow contributing up to 100% of a worker’s salary but within IRS limits. We use 6% to be conservative. This is lower than the average and median rates but starting here approximates worker behavior in that he or she starts contributing at a low rate that increases with age. The 3% company match is approximately the median value while the average value is roughly 2.7% - 3.5%. Reportedly, company matches are recently increasing but I will use the median value in order to be conservative in my model.
One difference between my model and many websites is that I assume an annual 0.25% increase in contribution rate up to 10%. So by year 17 a future retiree is contributing 10% of their salary. I choose 10% as the maximum since a relatively smaller percentage of workers contribute at higher rates. The current IRS 401(k) contribution limits are $19k but we assume that this will increase $500 every other year to reach a limit of $25k by year 25 and $26k by year 30. In addition, the IRS permits a catch up contribution of $6k for those 50 or older, which will also periodically increase. Hence in this scenario even those earning a salary of $100k today at age 30 will not exceed the IRS limits for employee contributions or for maximum total contributions.
In the chart below we see the annual contributions as a function of time using the above assumptions and a salary range between $30k and $100k.
Estimated Annual 401(k) Contributions For Salaries Between $30k and $100k
Source: Dividend Power Calculations
In the table below we see the total contributions for the same salary range assuming a 25-year retirement savings period or 30-year savings period. Over time the contribution amount is fairly large as function of starting salary.
Total Contributions After 25-years or 30-years As A Function Of Starting Salary
Starting Salary | Time Period | |
25 years | 30 years | |
$30,000 | $130,431 | $173,784 |
$40,000 | $173,908 | $231,712 |
$50,000 | $217,385 | $289,640 |
$60,000 | $260,862 | $347,568 |
$70,000 | $304,339 | $405,496 |
$80,000 | $347,816 | $463,424 |
$90,000 | $391,293 | $521,352 |
$100,000 | $434,770 | $579,280 |
Source: Dividend Power Calculations
A worker has some degree of control over the total contribution amount by varying the percentage of annual salary as a contribution amount. I performed a sensitivity analysis to show the effect of changes in starting percentage of annual salary contributions between 4% and 7% on total contributions for a 25-year and 30-year time period, as seen in the table below. The remaining assumptions stay the same. Within a range of reasonable starting percentages the contribution amount differences can be large particularly at higher salaries. Notably a future retiree can through contributions alone reach a significant fraction of the dollar value qualifying as financially comfortable according to the survey by Charles Schwab after a 25-year or 30-year time period.
Total Contributions After 25-years or 30-years As A Function Of Starting Salary And Starting Contribution Amount
Source: Dividend Power Calculations
How Much Will I Really Have For Retirement In My 401(k)?
This question is equally important. So I now add investment returns to my retirement savings modeling making the following assumptions:
- Monthly deposit at the beginning of each month,
- Annual compounding, and
- 8% annual rate of return.
I view an 8% annual rate of return as conservative. I make the assumption here that the future retiree has portfolio allocation of 60% stocks and 40% bonds, such as a combination of Vanguard Total Stock Market ETF (VTI) or SPDR S&P 500 Trust ETF (SPY) or Vanguard S&P 500 ETF (VOO) and Vanguard Total Bond Market ETF (BND) or iShares Core U.S. Aggregate Bond ETF (AGG). This portfolio allocation historically had an average annual return of 8.8% between 1926 and 2017. In addition, this particular portfolio allocation is reportedly popular since it has equity-like returns with less risk. The main benefit of this portfolio allocation is the negative correlation between stocks and bonds over time leading to lower volatility. In any case, an 8% annual rate of return is slightly lower than the historical returns of this popular portfolio allocation and thus conservative.
In the chart below we see the estimated dollar value in a 401(k) portfolio as a function of time using the above assumptions and a salary range between $30k and $100k.
Estimated 401(k) Dollar Value For Salaries Between $30k and $100k
Source: Dividend Power Calculations
In the table below we see the 401(k) dollar value for the same salary range assuming a 25-year retirement savings period or 30-year savings period. Over time the dollar value is substantial as function of starting salary. The important point here is that the difference in dollar value after a 25-year and 30-year time period is significant due to the power of compounding. These extra five years can be the difference between being considered financially comfortable or not according to the Charles Schwab survey. The lesson learned here is to start saving for retirement earlier and not later. But even for those starting at age 40 a reasonably high 401(k) dollar value can be attained after 25 years.
401(k) Dollar Value After 25-years or 30-years As A Function Of Starting Salary
Starting Salary | Time Period | |
25 years | 30 years | |
$30,000 | $331,134 | $539,079 |
$40,000 | $441,512 | $718,772 |
$50,000 | $551,890 | $898,465 |
$60,000 | $662,268 | $1,078,158 |
$70,000 | $772,645 | $1,257,851 |
$80,000 | $883,023 | $1,437,544 |
$90,000 | $993,401 | $1,617,237 |
$100,000 | $1,103,779 | $1,796,930 |
Source: Dividend Power Calculations
Now lets examine the effect of changes in starting percentage of annual salary contributions between 4% and 7% on 401(k) dollar value for a 25-year and 30-year time period, as seen in the table below. Due to the power of compounding the starting percentage has a significant effect on the 401(k) dollar value. A change of 1% - 3% can lead to a difference of tens or hundreds of thousands of dollars depending on the starting salary and time period.
401(k) Value After 25-years or 30-years As A Function Of Starting Salary And Starting Contribution Amount
Source: Dividend Power Calculations
Final Thoughts
Is the model accurate? As a check of the model, I use the AARP 401(k) Savings & Planning Calculator and assume a constant contribution rate of 6% annually. At a salary of $30k my model gives a 401(k) dollar value of $266,380 after 25 years and $427,770 after 30 years. This compares will to the results from the AARP calculator that gives a 401(k) dollar value of $267,750 after 25 years and $429,970 after 30 years. These differences are less than 1% and thus I view my model as accurate.
There is degree of uncertainty in the future values when modeling 25 years or 30 years in a retirement savings model due to life circumstances and human behavior. But at the same time it’s clear that a worker can achieve a value that is considered financially comfortable through a combination of planning and compounding. Even when starting at a comparatively late age of 40 one can attain a dollar value that may possibly meet retirement needs, particularly when combined with social security and other investments such as dividend growth stocks. Early investment in Dividend Kings or Aristocrats such as 3M (MMM), T. Rowe Price (TROW), Illinois Tool Works (ITW) and other companies that can grow dividends over time will lead to greater probability of meeting expenses in retirement.
Disclosure: I am/we are long MMM, TROW, ITW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.