Dialed In

Jonathan Clements

HOW DO WE GET FROM here to retirement? Amid the financial markets’ daily turmoil, it might seem like one big crapshoot.

But in truth, navigating this journey is pretty straightforward, because there are just five key variables—our time horizon, current nest egg, savings rate, target nest egg and investment return. With a few tweaks to these “dials,” we may discover it’s far easier to reach our retirement goal. Which dials are most effective? Much depends on how close we are to retirement age.

To get a handle on the issue, imagine the goal is to retire at age 65 with today’s equivalent of $1 million, which should be enough to kick off $40,000 in retirement income, assuming a 4% withdrawal rate. After adjusting for inflation, let’s also assume stocks earn 4% a year and bonds 0%.

That brings us to our base case: We begin investing for retirement at age 25 with a mix of 60% stocks and 40% bonds. We sock away a little over $15,000 a year, with that sum rising each year with inflation. If all goes well, our nest egg should—in today’s dollars—be worth some $169,000 at age 35, $384,000 at age 45, $655,000 at 55 and our coveted $1 million at 65.

Boosting returns. Does saving $15,000 a year seem too onerous? Remember, while I’m assuming that we step up the sum we save each year with inflation, our ability to save should rise faster than that over our career, as we get pay raises that outpace the inflation rate. The upshot: Even if we can’t hit $15,000 in annual savings during our initial working years, that target may be much more manageable later on.

Still, if we want to dial down the required annual savings rate, the No. 1 thing we can do is raise our portfolio’s expected investment return, especially if we’re early in our career. We can do that by cutting investment costs and making the most of retirement accounts. But the key step is to allocate more to stocks. For instance, if we opted for 80% stocks rather than 60% from the get-go, the required savings rate starting at age 25 drops from above $15,000 a year to around $12,700.

Meanwhile, if we’re closer to retirement, continuing to invest aggressively can also pay handsome dividends—assuming the stock market performs as hoped. But for market returns to be a big help at that late stage, we need to have been good savers up until that point, so we have a plump portfolio to benefit from those expected higher stock returns.

If we haven’t been such good savers, investment returns become less crucial. Let’s say we’re age 50, have $100,000 saved and hope to hit $500,000 by age 65. Even if we hold 80% stocks rather than 60%, that only trims the required annual savings rate from $20,000 to $18,000. On top of that, there’s a greater danger of disappointing investment returns, given the relatively short time horizon.

Delaying retirement. So what’s the best strategy if we’ve been tardy with our retirement savings? We might postpone retirement from, say, age 65 to 67. If we’re age 50, with $100,000 saved and $500,000 desired at retirement, delaying retirement by two years trims the required annual savings from $20,000 to $17,000. What if we both delay retirement by two years and hold 80% stocks, rather than 60%? That cuts the necessary savings from $20,000 a year to below $15,000.

While a two-year retirement delay can be a smart move if we’re late to the savings game, it shouldn’t be necessary if we’ve been good savers for much of our career—and it probably won’t make that much difference to our required savings rate. With 60% in stocks and a $1 million goal, our hypothetical 25-year-olds still need to save $14,000 a year if they delay retirement from age 65 to 67—or, alternatively, if they start saving at age 23 rather than at 25. In other words, toughing it out in the workforce for two more years only cuts the required savings rate by roughly $1,000 a year.

I’m not arguing that $1,000 less per year isn’t meaningful. But if we’re already saving for 40 years, tacking on an extra two years is far less crucial than it is for those who start late. Don’t want to delay retirement past age 65? Do the obvious: Save diligently in your 20s and early 30s. Indeed, if we don’t start saving until age 35 or so, postponing retirement by two or three years may be our only choice if we want a financially comfortable retirement.

Trimming the target. If we start saving late in life, we’ll likely need every dollar we can amass—and we’ll probably end up with far less than $1 million. By contrast, if we start saving diligently at age 25, we might discover we have more than enough for a comfortable retirement, especially once we factor in Social Security.

For instance, imagine we began saving $15,000 a year at age 25 and got to 55 with the $655,000 nest egg mentioned above. And then—bam!—we’re laid off, or we decide to go part-time, or perhaps we want to pursue a different career. Whatever the case, we end up with a lower income and hence less ability to save.

What to do? To hit our $1 million, we could invest more aggressively or delay retirement by a few years. But perhaps the wiser course is to lower our target nest egg from $1 million to $900,000. If we do that, the required annual savings rate over our final 10 years in the workforce drops from $15,000 to just $6,000.

One final scenario: What if we want to retire early? If our goal is $1 million and we hold a 60-40 stock-bond mix, we could retire at age 58 if we save $20,000 a year starting at age 25, with that sum rising each year with inflation. What if we save that $20,000 a year, while also holding an 80-20 portfolio? If the markets perform as expected, we could potentially retire 10 years early—at age 55.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Ain’t EverythingBad Influence and Never Assume.

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