Saving For Retirement
Paying Yourself First. It’s not too late
HOW MUCH SHOULD YOU BE PUTTING AWAY?
The Importance of Implementing a Disciplined Savings Routine
A very common question that financial advisors are often asked today is, “When should I start saving for retirement and how much do I need to save?” Depending on the individual circumstances of your life the answer can vary, but there is one simple answer that will never be wrong:
START SAVING AS MUCH AS YOU CAN, AS SOON AS YOU CAN.
The sooner you start saving, the more time your money will have to grow and benefit from the effects of compounding, which will minimize the amount you need to contribute to your retirement savings.
There are several principles used to formulate the calculations necessary to answer our question. First and foremost is the ‘Retirement Rule of 20’. The Rule of 20 is a rule of thumb designed to help you estimate the amount of savings you will need to generate your desired retirement income. In simple terms, the rule states: to generate $1 of inflation adjusted retirement income you will need $20 of retirement savings. While this number is not precise and will vary slightly depending on the circumstance, it is a good guideline which considers factors such as inflation, longevity, market volatility, age of retirement, taxes, and probabilities.
The second principle in this example is the calculation used to figure out how much annual income will be needed in retirement. This figure can vary significantly depending on your current lifestyle and that which you would like to live in retirement. A commonly used figure is that most people will only need 60-80% of their pre-tax gross employment income to live off in retirement. This assumes you will have lower expenses in retirement than when you were working. For our example, we have chosen to use 50% of pre-tax gross employment income to further illustrate the importance of disciplined saving. If we used the 70% figure you would need significantly more funding; many Canadians will fit into this group. This example is not a worst-case scenario; it is a relatively conservative estimate of what someone could need.
Finally, we need to account for government benefits like CPP and OAS. The amount you receive in government benefits can vary greatly depending on many factors during your working life. However, using statistical averages provided by Statistics Canada you will find that for many Canadians, government retirement benefits will cover about half of their retirement income needs. This means that we only need to fund about half of our retirement income from your own savings.
The following table uses the example of a 25-year-old Canadian currently earning $40,000 of income annually. Using the principles and assumptions that have already been mentioned we are able to calculate the inflation adjusted income at age 65, the dollar amount of annual retirement income required, and the amount of capital required to fund the full retirement.
SAVE FIRST AND SPEND WHAT IS LEFT OVER
As you can see in the table, the difference between starting early and waiting for later in life to save for retirement is staggering. You will see in the table that if you start making these contributions to your own personal retirement savings at age 25, you can reach your goal with total annual contributions of about 10% of your gross income or about $340 a month in the example. But if you wait until age 35, you now need to achieve a savings rate of nearly 15% of gross income or nearly double the monthly payment after considering inflation. The longer you wait the more difficult the savings requirement. If you started at age 55 you would need to save almost half of your gross income to meet your retirement savings need. Very few Canadians can set aside 50% of their annual income for savings without making drastic changes to their lifestyle.
You will also notice the actual total dollar amount that you would have to contribute out of your own pocket in each scenario. Someone who starts saving at age 45 will need to contribute more than double than that of someone who started contributing at age 25. This is because of compounding over time and the loss of 20 years of savings and growth. This means that if you start contributing early and therefore do not need to contribute as much; you will have more money to spend during your working years than you would have if you started saving later. Of course, not saving at all will give you the most to spend during your working years, but then you will have to work until the day you die and hope you never have poor health.
Can you now see how important it is to start saving as much as you can at an early stage? For most people saving seems hard but it really isn’t that difficult. The reason it is challenging for most individuals is because they don’t have a budget and they spend money without giving it much thought. Spending is not the key to saving. Don’t plan to spend and then save what is left over. Plan to save and then spend what is left over. This is often referred to as ‘paying yourself first’. If you currently spend close to 100% of your monthly income you will need to create a budget to determine where your money is going and then decide on your savings level. If you are one of many North Americans who are living outside of your means, it will be difficult to get started. However, all you must do is decide on the number that you will save each month and then be sure to always pay yourself before you pay any bills or expenses. The money should be put in an account separate from your regular banking account where access to the funds is limited. You may consider setting up an automatic contribution plan where you don’t even have to think about setting money aside, because it will be set aside for you.
If this example creates doubts in your mind or makes you concerned about whether your retirement goals will be met, don’t hesitate. Call your Keybase Financial Advisor today and set up a meeting to discuss how to start paying yourself first so that you don’t ‘pay for it’ later.
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