Why Has Retirement Changed?

In 1978, Congress passed the Revenue Act of 1978. It included a provision, Section 401(k), that permitted employees to defer compensation from bonuses or stock options tax-free. It went into effect in 1980.

By 1981, the IRS issued rules expanding 401(k) plans to permit employees to contribute through salary deductions, and by 1983 nearly half of all large firms offered or were considering offering a 401(k) plans.

Companies loved it - 401(k)s were far more affordable for them than pensions. And over the last 40 years, the way we fund retirement has shifted dramatically.

In 1980, 60% of private sector workers were covered by defined benefit plans. Defined benefit plans, more commonly known as pensions, were retirement accounts where the employer put up all the money, promising the employee a set payout when you retire. These benefits were a huge expense for employers, but led to major employee loyalty.

By 2006, only 10% of private sector workers were covered by defined benefit plans only, with 2/3s now under defined contribution plans, like 401(k)s or 403(b)s - the version of a 401(k) for government and non-profit employees.

This reduced costs for employers tremendously, but shifted the burden of saving for retirement almost entirely to employees. And we don't save nearly enough.

But What About Social Security?

This could be an entire post in itself, but here's the gist. For the same reason that defined benefit plans were extremely costly for employers, social security is too. Yes, employees paid into social security as they worked. And benefits were paid out as they retired. But what was collected was estimated based on their future retirement need - including estimating cost of living increases and life expectancies.

And along the way, people started living longer. This wasn't too bad as long as there were a lot of people still working and paying into social security, and when interest rates were higher and the assets in the social security trust were earning more.

But as the Baby Boomer generation started retiring, there were more and more of them collecting benefits. Currently, the interest on assets in the Social Security trust, collected over the years from surpluses, is enough to bridge the gap between what is collected from employees every year, and what is paid out in benefits... but based on current projections, the assets themselves will have to be used soon, and the entire system is expected to be exhausted by the early 2030s.

Benefits will have to be cut, retirement ages extended, contributions increased or some combination of all of the above for Social Security to continue... but for 20-40 somethings now, I wouldn't count on those benefits.

So How Much Should I Save for Retirement?

To answer the question, "How much money should I save for retirement?", you just have to answer a few simple questions. Using the answers to the questions below, fill in the pink boxes on the FREE downloadable Retirement Calculator spreadsheet at the end of this post. Don't fear the spreadsheet - just plug-in your answers, and it does all the math for you!

When do you want to retire?

You need to decide the age at which you plan to retire. This is important for two reasons. First, it determines how many years from now you have left to save. And second, it will also start the clock on when your retirement begins.

One thing to keep in mind, a big expense for you in retirement is healthcare benefits. When you leave your employer, if you were receiving your health insurance benefits through them, the cost of these benefits will likely shift to you.

Medicare is our country's health insurance program for the retired and disabled... but only begins at age 65 or older. The cost of healthcare benefits is often why many do not retire until age 65.

How long will you live?

This is the million dollar question. The best we can do is estimate, based on life expectancy and your own family's longevity.

On average, Americans life expectancy is 78.6 years. Women are expected to outlive men by 5 years on average, with a life expectancy of 81.1 years vs. 76.1 for men.

This number is important to determine how long you will spend in retirement. Your life expectancy less the age you plan to retire is the number of years you will spend in retirement.

What will you spend annually?

Many will advise you to estimate spending less in retirement than you do now. You may plan to own your home outright by then, and/or downsize.

However, most people plan to "live a little" in retirement, and healthcare costs should again be taken into consideration. The average couple retiring today at 65 will need $280,000 to cover health care and medical costs in their retirement. This is after Medicare benefits and includes the costs of premiums, drug coverage, out-of-pocket costs for deductibles, as well as some services and devises not covered by Medicare (hearing aids). This cost is for a couple retiring today - it will be even higher by the time you or I retire.

At a minimum, I recommend planning to spend what you spend now. You should also consider whether or not you will still be supporting children when you enter retirement.

Finally, determine if you will have any other sources of retirement income. Do you have a pension or a defined benefit plan? These benefits will offset the income you need to save for yourself in retirement.

How Much I Need to Save for Retirement

Once you have the three answers above, you can do simple math to find your nest egg target. Your estimated annual spend in retirement (less any additional income sources) times the years you plan to be retired equal how much you need to save to retire.

You can make it more complicated worrying about inflation and returns in retirement, but generally, I would say once you retire, invest your assets in low risk, low return assets that offset the inflation impact, eliminating these complications.

How Much Should I Save for Retirement Every Year

The number above may seem huge and totally unattainable. Here's where the years you have between now and retirement matter. You need them for the magic of compounding to work!

Using an annuity formula, you can determine how much you need to save each year to reach your future target. You will need to input:

1. How much do you currently have saved for retirement?
2. The estimated annual real return on your retirement investment

Your estimated annual real return is what you expect your investments and savings to earn each year, less the impact of inflation. This estimate should be informed by what the long-term return of the stock market is and how aggressive or conservative you plan to be.

The long-term average annual return of the S&P 500 is 9%, less 2% inflation, is 7%. If you plan to invest more aggressively, your estimated real return may be higher; if you plan to invest more conservatively, balancing your portfolio between stocks and bonds, estimate less.

Get Your Retirement Calculator

Click below to download your FREE Retirement Calculator spreadsheet. Please do not be afraid of the spreadsheet - it's set up for you. All you have to do is input your answers to the questions above in the pink boxes, and it will do all the math for you!