How much do your employees need to save for retirement?
As a rule of thumb, they should save a minimum of 10%. Some will need to save a higher percentage if they do not have other savings or investments or started saving late, while others may need to save less if they have other outside income or investments to replace their income.
How do you determine how much income you will need once you reach your retirement years? In the financial services industry, we use what we call the “income replacement ratio.” On average, you will need to replace 70%, 80%, or 100% of your current income, adjusted for inflation, so you have enough money to pay for the things you desire to do when your current paycheck stops.
Let’s say you’re 40 years old, your current income is $50,000, and you want to stop working when you’re 65. Let’s also assume your house will be paid off and your children are grown and no longer on your payroll. Because these two large expenses are gone, you’ll probably only need 80% of your current income at retirement.
We also need to take into account the impact of inflation on your future living costs. 50 years ago, a gallon of gas cost 23 cents. This morning when I filled up my car, it cost around $3.50. That’s the effect of inflation—as the cost of goods and services goes up over time, it will make your income worth less in its future purchasing power.
To quickly calculate the future impact of inflation on your income, you can use the Rule of 72. This is a simple mental-math shortcut to estimate the impact of inflation on eroding purchasing power of your money or to understand the nature of compound interest.
Here’s the formula: interest rate divided by 72 equals the number of years it would take for your money to double. For example, if you can grow your money by 8% every year, how quickly would that money double? Simply divide 72 by eight, which equals nine. So, your money would double every nine years. The Rule of 72 can quickly tell you how quickly inflation will erode your money. If the inflation rate is 3%, then your money will lose half of its value in 24 years because 72 divided by three is 24.
Now let’s go back to our original scenario—you’re 40 years old and your income is $50,000. Assuming inflation is 3% for the next 25 years, how much will you need to earn to maintain your current standard of living at age 65? Just divide 72 by 3% and you’ll get 24. In 24 years, that $50,000 will only be worth $25,000 in purchasing value. 3% inflation over 24 years reduces your purchasing power by 50%. Put another way, you’ll need more than twice your current income—or $100,000 a year by age 65—just to keep pace with inflation.
Today, just about every 401(k) record-keeper website will calculate your employees’ income replacement ratio. Some will even convert how much an employee has saved into a monthly income figure at retirement to give them an idea of how on track or not on track they are to replace their current monthly income at retirement. If you’d like to know which record keepers offer these calculations and benefits, just send us an email.
Understanding these rules and calculations is critical in supporting your employees and knowing how much they need to save for retirement. Communicating this information to your employees on a regular basis is even more important. If you’d like to know more about a simple tool we call the “gap statement,” which we use with our retirement plan clients to help communicate to their employees what their income replacement ratio is, you can send us an email as well and we’ll send you an example of this impactful tool.
If you have any questions about this topic or you’d like to schedule a no-obligation appointment, feel free to give us a call or send us an email. We’d be happy to help you.