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How Much You Need II

For most of us, retirement won’t resemble our father’s (or more likely grandfather’s) retirement.  The responsibility for funding our retirement has shifted from the employer to the employee.  To facilitate this shift more private sector and public sector employers have implemented defined contribution (DC) plans to help their employees save for retirement.  Plans such as the 401k, 403b, and 457 fall into this category.

Now that we have the primary responsibility for saving for our retirement, we must answer two questions to be successful:

  • How much income do I need to replace?
  • How much do I need to save?

Research by Marlena Lee of Dimensional Fund Advisors provides an answer to the first question.  The following table summarizes the results of her research.

 Source: “The Retirement Income Question”  Marlena Lee, Dimensional Fund Advisors

Source: “The Retirement Income Question”  Marlena Lee, Dimensional Fund Advisors

To recap, the average person needs to replace 23% to about 40% of their working income through income derived from their savings.  Social Security will make up the difference.

To answer the second question, “How much do I need to save?” we turn to research by Massi De Santis and Marlena Lee of Dimensional Fund Advisors.  Their paper, “How much should I save for retirement?” provides evidence-based answers to that question.  For details, please refer to the paper (link provided at the end).  

Some key points from their research are:

  • Saving consistently, and early (say age 25) throughout your career gives you the highest chance of acquiring sufficient retirement savings
  • Investing for the long-term (no market timing) increases the chances of success.
  • Aiming for a 95% chance of reaching your goal will require saving more than aiming for a lower chance of reaching your goal
  • Higher income earners need to save a higher percentage of their income than lower income earners.

The following table shows the savings rates required for a 25 year old at selected income levels.  95% and 90% success probabilities were selected to show how the cost (savings rate) increases as the success probability increases.  The De Santis & Lee paper has more comprehensive results.

 Source: “How much should I save for Retirement?” Massi De Santis and Marlena Lee of Dimensional Fund Advisors

Source: “How much should I save for Retirement?” Massi De Santis and Marlena Lee of Dimensional Fund Advisors

Most of us will need retirement savings to maintain our lifestyles in retirement.  In order to do so, we need to know how much our retirement will cost and how much we need to save for it.  Fortunately, we have answers to those vital questions based on research, not a hunch.

Read the complete article.

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