First, I’ll cover how much plan participants, on average, will need to save to create their paycheck for life for retirement.
Next, I’ll move on to something called the “Rule of 72,” which is a shortcut for figuring out how fast their money grows and how fast inflation can reduce the purchasing power of that paycheck for life.
On average, I like to tell plan participants that they need to save at least 10% of their pay, year in and year out, to effectively accumulate enough money to create a paycheck for life. More importantly, participants need to calculate how much of their current income they need to replace when they get to retirement and have that paycheck for life. This is a calculation we’ve found that most employees don’t bother with, which is unfortunate because it’s the most important number.
How is this calculation done? In this industry, we have a technical word for it called the “income replacement ratio,” or the “income replacement formula.”
It works like this: On average, when a participant reaches retirement age, they’re probably not going to need 100% of their income; they will probably only need 70%, 80% or 90% of it. Why? Let’s imagine that at 40 years old, their annual income is $50,000, and they decide that they want to retire at age 66 and start collecting that paycheck for life. We’ll also assume that they’re going to get social security, which will make up for a portion of that income replacement. If the participant is only going to need 80% of their income, that would equate to $40,000. That’s $40,000 in today’s dollars, but complicating matters is this little problem called inflation.
The economic definition of inflation, in layman’s terms, is too much money chasing too few goods. Inflation basically erodes your purchasing power over the years, so a participant needs their income or their savings to grow in order to keep up with the cost of living.
This is where the Rule of 72 comes into play. The Rule of 72 is a shortcut to figuring out how fast the participant’s money is going to be eroded by inflation. The Rule of 72 helps to calculate how long they have until their income erodes to half of what they are currently making. So, since the inflation rate is 3%, you’ll take 72 and divide it by three. If the inflation rate was 4% and 5%, you would divide 72 by four or five. 72 divided by three is 24, therefore it would take 24 years for a $50,000 income to erode to $25,000.
Let’s turn this calculation around under the same assumption of working until age 66 with an annual income of $50,000. Replacing 80% of that $50,000 would equate to $40,000. However, in 24 years, that $40,000 is only going to be worth $20,000. That means a participant would actually need $80,000 just to keep pace with inflation when they get into their mid-60s.
If you’re thinking that this sounds too complicated or you’re wondering how plan participants are going to calculate this, I have good news. Most 401(k) recordkeepers have calculators that will help participants calculate their income replacement ratio and the effects of inflation. As a matter of fact, there are even some recordkeepers who, instead of giving out a statement of a lump-sum amount of how much money the participant has accumulated in their plan, they’ll actually convert that amount to a monthly income at the participant’s retirement age.
For example, if somebody needs $2,000 a month to live on and they have only $1,350 projected income, the calculator will notify them that they’re short $650 and inform them how much additional money they would need to save at a reasonable rate of return at 3% inflation in order to create that paycheck for life.
If you’d like a list of the record keepers that actually do those calculations or convert the lump sum amount that they’ve saved into a monthly amount, email me at cdepstein@The401KCoach.com
What we’re covering here is mission critical. If plan participants don’t know how much income they need to replace, what inflation will do to their paycheck over time, and what they need to save, they’re going to end up without enough money in their retirement account to create that paycheck for life.
One way we can help plan participants understand exactly how much they need to save is using something called a “gap statement.” The gap statement simply performs this calculation for them. As a matter of fact, with all our clients, we create a gap statement for all their employees. If you’d like a sample copy of our gap statement, feel free to email me again at the aforementioned address.
If you have any other questions about this topic and you would like to connect with me, don’t hesitate to send me an email. I look forward to helping you.