The Simplest Financial Plan of All

 A very simple financial plan--the simplest of all, in fact--is to save a significant percentage of your income. If you save about 15% to 20% of your pretax earnings, work for 30 or more years, and invest in a reasonably well-diversified portfolio of stocks and bonds, you'll have a good chance of maintaining your pre-retirement standard of living during your golden years. It's not easy to save this much. But if you can, you'll probably build a good-sized portfolio while keeping your standard of living under control and sustainable in your golden years. If you save a smaller percentage of your pretax earnings, like 5% or 10%, you'll have to make some cutbacks in retirement (although you'd still be better off than most Americans). 

 One advantage of the percentage of earnings approach is that you won't need to fuss around with financial calculators that give you seemingly impossible retirement targets, which need to be revised every year or two to account for inflation. Any reasonable estimate of your needed retirement savings will be in the high hundreds of thousands or the millions of dollars. These numbers seem so intimidating and impossible that many people don't even bother to start saving. That's a mistake. Forget about the seemingly impossible dollar amount and instead focus on saving a percentage of this year's income, then next year's income, and so on. After a few years, saving becomes easier and your wealth will grow visibly. 

Another advantage of using a percentage of your earnings as a saving target is that you won't have to budget specific expenses. You can spend as much as you like on lattes, clothes, cars, vacations and whatever, so long as you save the requisite percentage of your earnings. You can still indulge and spoil yourself in some ways, maybe even excessively, as long as you maintain the targeted retirement savings level. No need to input each day's expenditures into your computer, or debate whether chocolate is an extravagance or a necessity. Anything goes, as long as you fund your retirement adequately. 

 Saving isn't easy. But a simple financial plan will make it easier.  You've already read enough to put this simple plan into action. If you want a more detailed explanation of why the percentage of earnings method works, keep reading. But . . . Trigger Warning: Math lurks below. The simplest financial plan of all is based on a straightforward idea: the more you save, the less you spend today and the less extravagant your current lifestyle. You'll save more and have a less expensive lifestyle to maintain in retirement.  In other words, by controlling your spending today, you leverage your ability to save for retirement without a loss of lifestyle. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle. 

Look at the numbers. If you’re spending 100% of your current income, you’ll save nothing for retirement, and have just Social Security benefits. Get used to eating dog food. If you spend 95% of your pre-tax earned income (we count taxes as spending because you don't save the taxes you pay), and save 5% in a 401(k) account—adjusting your contributions upward annually for inflation--you’ll have a decent sized nest egg after 30 years. If we assume annual investment gains of 7% compounded, you'll have enough at age 65 to start withdrawing an amount equal to about 19% of your average annual pre-retirement income. (This assumes you're drawing down 4% of the initial value of your retirement assets per year in retirement, which is about as much as you should withdraw if you don't want to outlive your money.) Adding 19% of your working years' annual income to your Social Security benefits may not sound like a lot, but it’s certainly better than zero. If you're middle class, Social Security could amount to about 30% of your pre-retirement income. With another 19%, you'd retire on a total of about 50% or so of your average annual pre-retirement income. 

If you save 10% of your earned income in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income, starting at age 65 (assuming a similar 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d be withdrawing enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today leverages your ability to save and to maintain your current lifestyle in retirement. Add the 30% or so that Social Security would provide if you're middle class, and you'd retire on about two-thirds of your average annual pre-retirement income. 

Using the same assumptions, if you save 15% of your earnings each year, then you'd be able to withdraw about 57% of your average annual pre-retirement income during your golden years. Because you'd have been living on 85% of your income, the withdrawal would approximate 67% of your average annual pre-retirement spending. If you're middle class, add 30% or so for Social Security, and you would be able to spend about as much each year in retirement as you did, on average, before retiring. If you can save 20% or 25% of your earned income per year, you could actually end up with more lifestyle in retirement than you had while working. Let the good times roll. 

It’s important to note that these numbers are for your average annual earnings over the course of your life. Your average annual income for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off with lower incomes early in their careers and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher percentage. At least 20% of your earned income would be a good idea. We also don't count investment earnings saved and reinvested, since that is embodied in the compounding of earnings that leverages the growth of your savings. 

 What’s the right level of saving? That’s for you to decide. Each of us has a point where the trade-off between saving and current spending feels right. It won’t be the same for everyone. Pick a point along the continuum that makes you comfortable, and stick to the savings plan. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would be a more modest lifestyle now and a higher level of savings. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. While 15% has a good chance of getting you there, 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is quite possible since go-go years in the stock market--like the 2010's--are often followed by long periods of below average performance). Also, if you have fewer than 30 years to go before retiring, save 20% or more, if you want to avoid a drop in lifestyle during your shuffleboard years.

Good luck.

How To Think About Saving

Saving is easier if you think of it as an opportunity. Each dollar you earn is part of your finite lifetime income. Most people don't reflect on the finiteness of their lifetime income--the finiteness of their monthly income is painful enough.  However, we all have a limited lifetime income. Each dollar spent represents a saving opportunity lost. You can't save a dollar spent. It's gone forever. You can earn more dollars in the future. But those dollars further reduce your finite lifetime income. You can't earn more dollars and still have as much future income as you previously had. Yes, you can work longer than you expected. That appears to increase your lifetime income. But it's really an illusion. The reason people work longer is usually because they didn't save enough (including enough to compensate for stock market volatility as well as day-to-day retirement needs). So, all along, even though they didn't realize it, their habits and lifestyle doomed them to work longer than they expected. Their expectations changed, but not the finiteness of their lifetime income. The only thing they might have gained, perhaps, is greater self-knowledge. 

 If you save nothing during your working years, you can look forward to retirement on Social Security. Most people think old age and eating dog food are incompatible. But if all you have is Social Security, then dog food looms in your future whether or not you have a pet.  With the Great Recession that began in 2008 and the COVID Recession that began in 2020, saving has become fashionable. If you don't save, your net worth can quickly go negative if you're laid off or get sick.  

 In good times, the U.S. savings rate in recent decades has hovered around 4% of disposable income (i.e., the amount of earnings you have after paying income taxes).  Is 4% enough? Let's assume you're part of a household having an annual income of $100,000 dollars, with a marginal federal income tax bracket of 28% and a marginal state income tax bracket of 6%, and pay $25,000 total in federal and state income taxes (this figure may vary, depending on your state, deductions and credits). Your disposable income would be $75,000. Let's further assume that you save 4% a year, or $3,000, with $2,500 going into a retirement account and $500 in a regular bank account. Assuming you work 40 years, with an average inflation rate of 3% per year and an average return of 6% per year on your savings (stocks have a higher historical average return, but you shouldn't put everything in stocks), you'll have about $445,000. Adjust that figure for inflation and you'll have about $131,000 current dollars. Conventional financial planning wisdom dictates a person retiring at age 65 shouldn't spend more than about 4% of their retirement savings a year. With $131,000, that comes out to about $5,250 a year (a figure that can be adjusted for inflation each year). That would leave you scanning grocery store flyers for dog food sales. 

 Of course, just about everyone gets some Social Security. A relatively high income married couple that averaged $100,000 a year for 40 years might get something like $40,000 a year in Social Security (assuming one member of the marriage earned the bulk of the income and the other takes spousal benefits). A person living alone with an earnings history averaging $100,000 a year might get around $28,000 a year. Add either figure to $5250, and there's a better chance the dog food will stay on the store shelf. But these amounts only support modest lifestyles.  You can't do a lot to affect the amount of Social Security you get.  You have a lot more control over how much you save, and therefore how much you'll have in retirement.  

Retired persons tend to have greater medical expenses, and savings can disappear in a flash when a medical crisis comes up. While $131,000 is nothing to sneer at, it won't cover much more than one year in many nursing homes. And you'll have plenty of out of pocket medical expenses before you have to move to the nursing home. So you can't count on the $131,000 to be there late in life. Most people in their 70s and 80s probably wish they had more savings. The finiteness of your income means that saving is essential to retiring on more than Social Security. Every dollar spent now is a saving opportunity lost, one that can never be replaced. Saving isn't a sacrifice. You're buying a better retirement. If you want to maintain the lifestyle you have during your working years, save about 15% to 20% of your pretax income for 30 to 40 years. Such a savings rate can be difficult, but so is eating dog food (presumably; I haven't tried it). You can economize now or economize later. There's still no free lunch. Rugged individualism, America's cultural essence, today consists of having a stable financial foundation. The frontier is still there, but you no longer carve a homestead out of the wilderness and fill it with amber waves of grain. Today, savings and investment accounts substitute for 40 acres and a mule.