People who have a big home with an equally big mortgage, such that they have little left over each month after paying their mortgage payment are said to be “house poor.” Being house poor makes it difficult to save up for things, such that any little thing that happens outside the norm for the month becomes an emergency. There is also never enough money for investing, and credit card balances slowly grow as little extra expenses add up to big balances. A good way to avoid being house poor is to save up enough of a down payment and purchase a house inexpensive enough such that the payments don’t exceed 25% of your take-home pay.
I believe there is also such a thing as being retirement poor. This is when you are putting so much away for retirement that you never build up the taxable portfolio — the one that you can tap while you’re still below retirement age — that will allow you to find financial freedom while you’re still relatively young. This is the set of investments that allows you to not worry too much when there is a layoff at work because you can live off of your assets as needed until you find another job. It is also the money that allows you to start doing things in your mid-career like go on cruises and other nice vacations every couple of years year without going into debt, upgrading your home (or buying a bigger one for cash after you pay off the first one), and pay cash for progressively better cars if that is what you want. It also allows you to help out others around you since you have enough free cash to really give generously without a second thought.
Certainly saving for retirement is important and you don’t want to save up too little. As I’ve shown in other posts, having a little extra in retirement makes life a lot better than having just enough. If you have extra you can invest a portion more aggressively and increase your average return without jeopardizing the basics. Not having enough to last through retirement will result in living out your last days in poverty, either with an adult child to support you or on the government dole. Personally I think seniors should be the wealthy ones since they have had their whole lives to invest and save and new hires who are just starting out should be the ones getting the discounts. Unfortunately, many people don’t save enough.
So how do you tell if you’re on track for retirement, and if you’ve been saving diligently since you first started working, how do you know if you can slack off a bit? On the flip side, if you have not been saving that much or are getting a late start, how do you know if you will have not have enough for retirement and maybe need to increase your savings a bit?
If you are fully invested in stocks, a simple way to estimate your worth at retirement is to subtract your current age from your retirement age and then divide by 7. If you have a 50-50 bond mix, divide by 10. (If your retirement is in a savings account, just keep saving unless you have a couple of million dollars already. In other words, you need to start investing in stocks and bonds because savings accounts don’t provide the returns needed.) This will give the number fo times your investments will double between now and the time you retire if you stopped putting away money today. Then, raise 2 to that power and multiply by your current retirement savings to determine how much you’ll have at retirement based on your current investments. (Note, there are also a lot of good savings calculators online that you can use, but this is just a quick way to make an estimation.)
For example, let’s say that you are 30 years old and have $50,000 in your 401k. Let’s also say that you are mostly invested in stocks (which means you can expect a long-term return of 10% after inflation). If you plan to retire at 65, you have 35 years before you retire. 35 years divided by 7 equals 5, which means that you can expect your balance to double 5 more times before you retire if you keep it all in stocks. Two raised to the power of 5 is 32, so you can expect your retirement savings to be worth at least 32 times what it is today. Multiplying 32 times $50,000 would give you about $1.6 M in retirement.
So is $1.6 M enough for retirement? Well, divide that number by 20, and that will give you an estimate fo the annual income you can expect to get from that retirement portfolio if invested correctly. $1.6 M divided by 20 is $80,000, so you would be able to generate an income of about $80,000 each year from your retirement funds in 2014 dollars. (Note that I don’t include Social Security at all since it will not be there in 35 years, trust me!) If you are currently living on an income (money that you actually spend each year, not including money you are putting into retirement and elsewhere) of $80,000 or less and are happy, that may be enough and you can reduce your retirement savings somewhat and concentrate more on building your taxable portfolio for near-term expenses. If you want to up your lifestyle in retirement or just want to build in a bigger cushion, maybe keep savings as you currently are for a couple more years.
If your number is low, you might also want to see if you are putting enough away. A good rule-of-thumb is to put 10-15% of your gross salary away into a 401k, IRA, another retirement account, or a combination. You can also contribute to a pension plan if one is still available. If you do have a pension plan, you can reduce your savings rate in other accounts down to between 7-12%. The more you save, the more you will have at retirement. It is also easier to have enough if you put away more when you are young than when you are older. If you put away 12% when you are in your 20s and 30s you might be able to slack off to 8% when you are putting kids through college in your 40s and 50s. Conversely, if you don’t put much away before you reach 40, or you dip into your 401k along the way, you would really want to put in at least 15% to make up for the time you’ve lost. Note that this should be 10-15% before any company match because it is really difficult to find the money to make up for the loss of a company match if the company stops providing it. It is easier to never have the money for lifestyle in the first place than to cut back your spending and put more away for retirement.
If you don’t have enough money for your retirement now and want to be sure you are investing enough to get there at some point, you can use an online savings calculator. Simply plug-in your current balance and monthly or yearly contributions, along with a rate of return of 10% if you are going to be mainly in equities. (This assumes a return of 12-15% before inflation, reduced down to account for a 2-5% inflation rate.) You can then see what your account balance will be when you are ready to retire. If it is not enough to provide the monthly income you’ll need when you divide that amount by 20, start saving up more or plan to work a few extra years.
If you do find that you are retirement poor and will have far more than you will need in retirement, it is probably time to cut back on your retirement savings rate. This doesn’t mean that you should just stop contributing to retirement entirely. You may be leaving money on the table in the form of tax breaks and employer matches if you do, plus it doesn’t hurt to have a bit of a cushion. It also doesn’t mean that you should instantly increase your spending and blow all of the money you used to be putting towards retirement (although doing so to a point might be justified if you have been living on nothing for far too long). Instead, start putting a portion of the money you are no longer putting into retirement into taxable investment accounts and investing. Then, use a portion of the income you gain from these accounts to improve your life. For example, if you have $10,000 invested and it grows to $13,000 on year, you may choose to sell a few shares and pull out $1000 to buy some new furniture, go on a small vacation, or otherwise add to your life. You would then be reinvesting $2000, allowing the account to grow and provide more income in the future.
You can even have different accounts or mutual funds for different things. You could invest in one fund for vacations, one for home improvements, one for replacing vehicles, one to supplement your daily spending, and one for giving. Add these to your budget each year and decide how much you will harvest from these funds and how much you will allow to roll over and get bigger. With time these will become a major source of your income.
In the next post I’ll go into more details on controlling your cash flow and allocating to cuttent and future needs.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
