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Solving a retirement saving puzzle

Everyone knows how important it is to put money away for retirement. But if you save too little, you'll be poor later on. If you save too much, you may be denying yourself the good life today. So, how do you decide how much you should contribute to your 401(k) or IRA?

You could rely on guidelines published by such knowledgeable institutions as Fidelity Investments or the Boston College Center for Retirement Research (CRR). Both organizations suggest a contribution that's equal to 15 percent of your pay. This amount includes any employer contributions, so if your employer adds or matches 5 percent of your pay, you would only need to put away only 10 percent of your pay.

Both Fidelity and CRR base these suggestions on four important assumptions:

  • You want the same standard of living in retirement as in your working years.
  • You start contributing in your 20s or mid-30s and save continuously until age 65 (CRR's analyses) or 67 (Fidelity's analyses).
  • You retire full time.
  • You earn rates of return on your savings that are representative of historical levels.

Some analysts have criticized 15 percent of pay as being too high, reasoning that retirees' living expenses drop significantly as children move out of the house and they pay off their mortgage. True, but other life events can happen to counteract these savings, which could support an argument for higher contributions. For example:

  • You may lose your job or become disabled before age 65 and need to retire early.
  • You might experience interruptions in your savings for various reasons including job loss, child rearing and college education for your children.
  • You could get divorced and have to divide your retirement savings.
  • The stock market might crash just before your retirement.

Another consideration is the freedom you can experience if you accumulate sufficient amounts to retire.

Finally, the 15 percent suggestion assumes you efficiently deploy your savings when you retire and don't use high-price investments or insurance, or make other investing mistakes. Contributing smaller amounts may leave you with little margin for error.

Fifteen percent should really be just a starting point for your planning. Ideally, you'd take into account your own circumstances and goals, including:

  • The age at which you wish to retire
  • The amount of retirement income you really need
  • The amount of savings you've already accumulated
  • The rate of return you expect on invested savings

If you're the type of person who likes to juggle numbers, you can use one of the many online retirement calculators to help you determine the right amount to save. To personalize the calculation, these tools will ask you questions about the above topics and more. The more questions you're asked, the more "precise" the estimate will be (although it'll take longer to navigate the calculator).

For example, Fidelity offers one of the simplest calculators, which asks just three questions: your current age, how much you currently make and how much you've saved so far. It assumes you'll retire at age 67 and that you need a retirement income of 45 percent of pay, not counting income from pensions or Social Security.

Fidelity also offers more detailed calculators that allow you to input your own answers to the above questions. These are worth the effort if you want a more refined strategy.

No matter how you come up with a dollar amount, the truth is, any figure is, at best, a guesstimate that relies on assumptions you have to make about many items that may or may not come true for you. For instance, you can't predict exactly when you'll retire, you don't know how much your investments will earn and you don't know if you'll decide (or be able) to work a little in your retirement years.

If you're years away from retirement, you also might not be able to reliably predict how much you'll be willing to reduce your standard of living while gaining your freedom from work.

There's a wide range of possible "right" amounts you could save. It's probably a safe bet to assume that contributing less than 5 percent of pay is too little for most people; you might even fall short at 10 percent. On the other hand, you might be contributing too much if you can't enjoy a basic standard of living today.

Take your best shot at deciding how much to save for retirement, whether it's following generalized guidelines or doing your own calculations. Then revisit and readjust your savings amount every three to five years to account for changes in your goals and circumstances.

And be prepared to be flexible in your retirement years. If your savings fall short of an amount needed for a full retirement, you may need to work a little to make ends meet or be happy living on a reduced income. Then move on and enjoy your life.

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