Sunday, June 3, 2012

A safe savings rate

How much of your annual income should you save for retirement?

On one hand you can take a conservative approach and assume a very low rate of return.  This is along the lines of what Zvi Bodie argues, and I personally work on the assumption that my portfolio will earn about 3% in real terms which means that I have to save more.  Contrary to Bodie though, I don't invest all in TIPs, instead I have a more typical asset allocation.  The trouble with this method is that you can over save - meaning that you sacrifice too much now for the future.

Another approach  is detailed in a paper that was sent to me by one of my students (thanks Ben).   In this paper, the author estimated the proportion of income should be saved over 30 years to create a portfolio large enough to generate 50% of that persons salary into retirement.  The author used the past long term market performance to run the model.  The conclusion reached from the analysis is that you need to save about 16% of your income to fund your retirement.

There are some big caveats to this number though.  If you start late and only save for 20 years, then you'll need to save 30% of your income.

Bottom line:  If you are not saving between 15% and 20% of your income, then you better hope that your kids do well, because you're going to end up living with them.  

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