Okay. So you are putting away a little bit of money every paycheck into your 401(k). Or maybe you contribute to your Roth IRA. But how do you know if it’s enough?
When we answer this question for clients, we put together some pretty complex and sophisticated financial models that require a significant amount of time and expertise.
But assuming you don’t have ten hours and some really expensive software at your disposal, how can you tell if you are doing enough to meet your goals?
There’s an easy benchmark that you can use to help answer this question. Investment advisor and author Charles Farrell came up with the concept of applying simple financial ratios in his book “Your Money Ratio$.” We’ve adapted some of his ideas in our practice and find that simple ratios like these can give you a quick and reasonably accurate idea of how much you should be saving each year relative to income. Best of all, the concept is easy to understand and takes only a few minutes to apply.
Here’s how it works. All you need to do is add up what you save each year (including contributions to your 401k and other accounts) and divide it by your gross annual income. That will give you a ratio, which you then express as a percentage. For example, if you save $10,000 each year, and your gross income is $100,000, you are saving 10% of income. To interpret the results, see below:
If you save 10% or less of income: Keep trying! Increase your retirement plan contributions until you reach the 10% level. Start by contributing more to your IRA or retirement plan at work.
You are saving 10% of income: You’ve covered the basics, but you’ll need to do more to keep up. We used to think that saving 10% was enough, but today’s longer lifespans and rising healthcare costs have changed all that.
You save 12% of income: Good work! Try to increase contributions to 15% of income by adding a Roth or Traditional IRA.
You save 15% of income: Congratulations! You’re doing the right things to help meet your financial goals. Since few workers have pensions now, saving 15% of income (or even more if you can) keeps you on track for a comfortable retirement.
Got another minute? Here’s more information: T. Rowe Price offers a good online guide to retirement savings that’s well worth consulting. Their research supports our view that 15% is the new 10% (e.g. where several years ago, the consensus was to save 10% of income, now that figure has been upped to 15%). T. Rowe Price says their “analysis suggests that individuals generally should strive to save at least 15% of their pretax salary (including employer contributions) in order for their investments to replace 50% or more of their current salary in retirement, adjusted for inflation. Those who delay saving until late in their careers, however, may need to save as much as 25% or more of their salary, and even then they may not accumulate enough assets to reach their goal.”
Ouch! Now that’s financial tough love at work.