Retirement planning can be split into two phases, the accumulation phase and the spending phase.
The spending phase has been pretty well-studied, with the backbone of current financial planning being the 4% safe withdrawal rate. This concept was initially proposed by William Bengen in 1994 and popularized by Trinity University researchers in 1997. These studies propose that investors should aim to save enough money for retirement to withdraw 4% of their nest egg in retirement annually. In other words, you should aim to save 25x your annual retirement spending.
But how do you know how much to save each year in order to achieve 25x annual spending?
Safe Savings Rates: A New Approach to Retirement Planning
Wade Pfau attempted to find this safe savings rate in his study, “Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle“, which was published in the Journal of Financial Planning in 2011. Using a similar methodology as the Trinity University study (simulations using historical returns data), Mr. Pfau combined the accumulation and spending phases into a single giant calculator.
His goal was to calculate a safe savings rate over your lifetime that would enable you to reach the 25x annual spending requirement prescribed by the 4% rule with a high probability (i.e. under a wide range of market scenarios).
[Footnote: Mr. Pfau actually calculated a safe savings rate to ensure that your portfolio would reach 12.5x your final income. If you assume that you will spend 50% of your gross income in retirement, this number is the same as 25x your annual retirement spending. -WSP]
Mr. Pfau’s model takes 4 inputs:
- Planned length of the “accumulation phase” (i.e. how long you’ll be working and saving).
- Planned length of retirement.
- Target asset allocation in retirement.
- Replacement rate. The replacement rate is a more traditional method to estimate how much you’ll be spending in retirement, as a percentage of your final pre-tax salary. Mr. Pfau ran the numbers for a 50% and 70% replacement rate, but we will look at the more realistic replacement rate for physicians: 50% of final salary.
Just as the Trinity University study calculated the safe withdrawal rate to achieve a high probability of making your retirement money last through a 30-year retirement, Wade Pfau’s model defines the minimum savings rate that will help you achieve your target retirement with a high probability.
To calculate asset class returns, Mr. Pfau used historical return data from 1871-2009. During the accumulation phase, a 60/40 stock/bond allocation is assumed.
Results: Your Safe Savings Rate
The big takeaways from the paper are in the tables. The tables are a bit cumbersome because of the myriad assumptions, so I’ve summarized and condensed the table for the most common assumptions for physicians (30 years accumulation phase, 30 years retirement phase, 50% replacement rate):
| Retirement Asset Allocation |
Safe Minimum Savings Rate
|
| 40/60 | 19% |
| 60/40 | 17% |
| 80/20 | 15% |
Study Weaknesses
Physicians with student loans should bump up their safe minimum savings rate
The paper’s assumptions assume you start at net worth zero. Graduating residents often have $200,000 in debt or more to start their careers. The safe savings rate should be bumped up by a few percentage points for student loan payoff.
Taxes are not included
Because of the complexity and fluidity of the tax system, Mr. Pfau did not attempt to model taxes in his analysis. Adding taxes to his analysis would significantly decrease asset class returns, which would increase the minimum savings rates.
Conservative Asset Allocation
The 60/40 asset allocation during the accumulation phase is very conservative. Most investors have 80-90% of their investments in stocks during their early working years. Target-date funds typically have a 90% stock allocation until at least the age of 40.
While Mr. Pfau did not analyze other asset allocations, he notes that the 60/40 allocation may actually reduce the safe minimum savings rate because it reduces the volatility of market returns.
Study Takeaways
You need to save a healthy amount of your income
No matter how long you plan to work, if you plan on having a retirement of any significant length (e.g. 20+ years), you will need to save a significant amount for retirement during your working years. A 5% savings rate will not cut it.
A more aggressive allocation in retirement reduces your safe savings rate
One aspect of the above table is that if you plan to have a more aggressive allocation in retirement, then you don’t need to save as much for retirement. This is an extension of the results of the Trinity University studies — if you employ a more aggressive portfolio in retirement, you potentially could have a higher safe withdrawal rate.
A smaller retirement nest egg lowers your safe savings rate
It’s stating the obvious, but the lower your spending needs in retirement, the lower your safe minimum savings rate.
Unfortunately, higher savings rates mean less spending during your working years. Because spending during your working years is highly correlated with spending during your retirement years, super-savers may end up “saving too much” and have “trouble” spending down their money. It’s hard to switch a savings mindset to a spending mindset later in life.
Of course, this is a great problem to have compared to the alternative: spending too much and saving too little during the accumulation years, only to be financially forced to cut back and live a spartan retirement.
Conclusion
This research helps give a baseline savings rate to shoot for when planning your spending and saving during your working years. I think the numbers are a little bit low, as they do not account for student loans or taxes and use a more conservative asset allocation than the typical investor.
Of course, your savings rate does not have to constant throughout your career — many physicians choose to front-load their savings, doing a “financial fellowship” for a few years after residency to quickly pay off their student loans. In fact, it is financially beneficial to front-load your savings because of the power of compound interest.
What do you think? What is your savings rate? Do you think the listed safe savings rates are too high, too low, or just right?
Yeah, I started off with a negafice net worth of $308k. Definitely closer to most of our starting net worths than “zero.”
Also I agree that a high savings rate is beneficial in two ways: it decreases your monthyl spending which means you need a smaller nest egg (shorter time to retirement) and it also gets you there faster through having a more substantial amount of money going in each month. Seems this will get you to a lower number twice as fast.
Until my student loans are paid off I’ll be 100% stocks. After that I might scale back to 90/10 until I am 40 when I’ll go 80/20 or 75/25. Definitely not in a 60/40 mix though. That’s way too conservative!
Good post. Thanks for the read!
Thanks, TPP, I like your wealth accumulate ratio metric for people with student loans.
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Interesting. We all assume we will be fine but when you look at the math, some planning is definitely needed. Also asset allocation makes such a big impact….good food for thought.
super-savers may end up “saving too much” and have “trouble” spending down their money
My modest nest egg is doing well, but I’m aware I fall into the super saver category and be super frugal when I retire in ten years (hopefully at 55).
The question I come to is what is included in savings rate. Are matches for retirement accounts? Pre or post tax? We sit a around 47 percent of gross pre tax not including match.
After reviewing the paper, it appears Mr. Pfau used a simple formula of savings / gross income. He did not address taxes or retirement matches. Retirement matches would probably count as additional savings.
There is also a safety net. Many productive people will find it impossible to stop earning money. My side gigs that I built just to keep my brain engaged are making the six figures of income I need to keep a zero withdrawal rate with only part time work on my part. I don’t think I’m special, OK I do but that’s not important, I think many if not most will make good money in spite of themselves. The same discipline and focus that let people save up 25x makes them extremely valuable people in our economy and there will be lots of people wanting to pay them well for a little of their talent.
Certainly, if you can find something you enjoy doing in retirement that brings in enough income to cover your expenses, than that is the perfect scenario.
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