A Brief History
Prior to the 1980’s, if one’s employer provided a retirement benefit, it would come in the form of a Pension plan. The plan itself would dictate the benefit that each employee would receive upon reaching retirement, and the funds would be managed with these goals in mind. These pension plans were labeled “Defined Benefit” plans, referring to the fact that the employee’s retirement benefit would be stated in advance, and the employer would be responsible for any shortfall.
In the decades since, these Defined Benefit plans have largely been replaced by Defined Contribution plans, in which the plan is dictated not by the ending benefit, but by the amount allowed as contributions per year. 401(k)s and 403(b)s are two of the most common Defined Contribution plans, and if you have a retirement plan through your employer, it is likely to fall in this category.
Planning for Retirement
As the most common retirement plan shifted from Defined Benefit to Defined Contribution, the responsibility of effectively saving for retirement similarly shifted from the employer to the employee. This has made it necessary for each employee to act as their own retirement planner, which has led perhaps the most common question we receive from employees of retirement plans where we serve as advisor is undoubtedly: “How much should I save each paycheck?” Unfortunately, there is no one-size-fits-all answer, but there are multiple good practices to follow.
How Much Should I Save?
The first step in determining how much you should save is to consider how much money you will need in retirement. One good way of thinking of retirement is as a very long vacation – just as you might save and budget for a summer vacation (travel, food, entertainment, etc.), you should save and budget for retirement (fixed expenses such as mortgage/rent/utilities, living expenses such as food and entertainment, etc.) It is important to remember that most of these expenses will directly reflect what type of lifestyle you plan on living in retirement, and what your friends and family want might be different than what you want for yourself. One of the simplest ways to get a general sense of how much to save is by using a retirement planning tool. Nearly every retirement plan provider offers their own version on their website, take a few minutes to try out yours next time you login. A quick internet search will also yield various other tools that will surely help in the process.
Rules of Thumb
If you simply want help determining a good starting point, there are a couple points to consider to help start the saving process:
- Ensure you take full advantage of your company’s match (if available). For example, if your employer will match up to 3% of your salary, then contributing anything less than 3% is giving up free money. Think of this match as additional compensation that all you need to do to earn is to save for your own retirement (it is a no brainer!)
- Pick a high percentage goal that you would like to reach – 15% for example – and form a plan to reach it. Find an amount that leaves you with enough after-tax salary to live, and then form a schedule to escalate your contributions until you reach your goal. An example might look like:
- Start at 7%
- Every 6 months, increase your contribution deferral by 1%
- Stop increasing when your deferral reaches 15% after four years
The Bottom Line
Saving in an employer-sponsored retirement plan is extremely effective, because it allows for your savings to compound over time while deferring taxes until you use the money in retirement. The more money you can contribute now, the greater that sum will compound to be when you finally reach your “very long vacation.”
If you have any questions or would like to explore this question further, please call us at 1-866-915-5192.
The above writing does not constitute investment advice, rather they are general guidelines and/or for informational purposes. Every individual has differing needs that must be evaluated and examined by financial professionals and tax advisors. For more information about The Capital Group Investment Advisory Services, LLC and our investment philosophy, including information on fees, you may request a copy of our Form ADV Part 2A from our team at RIAInbox@capgroupfinancial.com.
Securities offered through Purshe Kaplan Sterling Investments, member FINRA/SIPC, Headquartered at 80 State Street, Albany, NY 12207. Purshe Kaplan Sterling Investments and The Capital Group Investment Advisory Services, LLC are not affiliated companies.