“How much should I save?”
This question is quite challenging to tackle independently due to the multitude of significant interconnected factors involved. These factors encompass various aspects such as your retirement age, the potential return you can safely guarantee on your savings, the inflation rate, the composition of your retirement accounts, your assets, outstanding mortgages, student loans, and other debts, and the list goes on.
While economics alone cannot dictate your course of action, it does offer a valuable framework for addressing this question. Enter consumption soothing, a concept that serves as a guiding principle for preserving your desired standard of living as you swift through life. Put simply – it entails aligning your spending in a way that allows you to maintain consistent levels of expenditure in future years when adjusted for inflation and other relevant factors.
By embracing consumption soothing, you strive to strike a balance between present and future consumption, ensuring that your financial decisions today do not compromise your long-term financial well-being. This approach acknowledged the dynamic nature of your needs and desires over time, recognizing that a dollar today may hold a different value and purpose in the future.
Once you have determined the level of sustainable spending for your desired lifestyle, a simple subtraction from your current income reveals the amount you need to save for the year. It’s as if a magical formula has unveiled this year’s required savings. This approach stands in stark contrast to the conventional planning methods often propagated by Wall Street and financial institutions.
The general advice from Wall Street is to continue saving as you have been, aim for a high post-retirement spending goal based on the 85 percent replacement rate rule, and invest aggressively to achieve that goal.
By investing aggressively, you increase the likelihood of maintaining your desired lifestyle throughout retirement without running out of money. However, this approach also carries a higher risk of running out of funds at an earlier age, like 65 instead of 85.
Economics teaches us a valuable lesson – there are no free lunches! Taking on more investment risk inevitably comes with increased spending risk. It’s a straightforward principle.
Moreover, economics also tells us that any rational individual, regardless of their financial means, would never willingly choose a plan that carries a probability of ending up with a low-quality lifestyle, lacking necessary medications, or being homeless.
Now, let’s engage in a little game. I will provide you with a scenario involving a single individual named Jason, and your task is to determine the amount he can spend to maintain the same real spending level until he reaches the maximum age of 100. Additionally, I will ask you to estimate how much Jason should save this year.
Once you have made your guess, refer to the end of this blog for answers. Note that the answers were swiftly calculated using the software.
You are bound to face a challenge in this quiz, similar to my own experience of failing despite taking help from the software. It is simply impossible for a human to think 30 moves ahead in chess. This analogy effectively highlights the intricate nature of personal financial decisions, which possess a comparable level of complexity.
If you’re unable to determine what Jason should do, it’s reasonable to assume that you’re also unable to determine what you should do. While you might be consulting a financial planner, it’s worth testing their expertise. Share the quiz with them, excluding the answers. If they also struggle to provide the correct answers, it’s crucial to acknowledge the apparent reality. Your planner may be offering misguided spending and saving advice, which could potentially jeopardize your retirement.
For those who do not utilize financial planners, it seems they assume that relying on a combination of social security benefits and their employers’ savings plan will be sufficient to maintain their financial stability even into their nineties. However, when faced with a shortfall, both the government and employers may join forces and recite the following refrain:
“It’s not our responsibility. While we made an effort to assist, it was necessary for you to determine additional ways to save on your own instead of solely depending on us.”
Jason, a 50-year-old resident of New Mexico, earns $130,000 per year. His income will keep pace with inflation until he retires at the age of 62, at which point he will begin receiving Social Security benefits. Jason started his career at the age of 25 in 1998 with an annual salary of $50,000. His nominal earnings increased by 3 percent each year, which is important in determining his future Social Security benefits.
Jason has accumulated $250,000 in savings, which earns an annual interest rate of 4 percent. The inflation rate is currently at 2.5 percent. Additionally, Jason owns a $1 million house with a 20-year mortgage worth $700,000. He pays $4,000 per month towards the mortgage and incurs annual expenses of $10.
It is worth noting that Jason’s maximum life expectancy is 100 years, and he has no intentions of selling his house.
What is the maximum amount Jason can spend in today’s dollars for the remaining 50 years while still covering his housing costs, taxes, and Medicare Part B premiums? Additionally, what amount does Jason need to save this year as part of his plan to maintain his current living standard?
Jason decides to make a single change by choosing to start receiving Social Security benefits at the age of 70.
In Case 03, Jason chooses to continue working until the age of 67 while making the same adjustments regarding his Social Security benefits.
In Case 04, Jason decides to relocate to Texas at the age of 70 while maintaining the same considerations regarding his Social Security benefits.
In Case 05, Jason opts to downsize his housing by half as part of his relocation to Texas while still incorporating the same elements discussed earlier, such as his Social Security benefits.
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