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Three keys to retirement savings

How the 3 A’s—account, amount, and asset mix—can provide the cash you'll need to retire.

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With pension plans becoming as rare as the gold watch at retirement, most of us need to face up to this stark reality: We will likely need to fund much of our retirement on our own. And that means saving early and often, taking full advantage of tax incentives, and investing wisely.

“Since we are living longer and facing rising health care costs in retirement, it’s critical to begin saving and investing early and smartly,” says John Sweeney, executive vice president of retirement and investing strategies at Fidelity. “After all, retirement income is the outcome. And to get that right, you need to focus on three main things during your working years: the amount you save, the accounts you save in, and your asset allocation. Of the three, of course, the first is the most important, as no account or asset allocation can compensate for inadequate savings.”

Call them the three A’s of retirement planning:

  • Amount. How much—and how long—you save is key. We suggest socking away at least 10%–15% of your pretax income each year (includes any employer matching and profit sharing contributions) to have a good chance of meeting your retirement income needs.1 Even if you can’t contribute that much immediately, make sure to defer enough to get the 401(k) match, which is effectively “free money,” and then step up your savings as soon as possible.
  • Account. Where you save also matters. Be sure to make the most of 401(k) and other workplace savings accounts where contributions can grow tax deferred. And if you are eligible, take advantage of health savings accounts (HSAs), which can offer the most effective means of saving for retirement health care expenses (See Viewpoints: HSA healthy habits). Individual retirement accounts (IRAs), deferred compensation, tax-deferred annuities, and other tax-advantaged savings vehicles should be considered as well. Also consider the advantages of a Roth 401(k), if available, or Roth IRA over a traditional version: While contributions are after taxes, earnings and withdrawals are tax free.2,3 (See Viewpoints: Roth or traditional IRA or 401(k)?)
  • Asset allocation. How you invest is also critical. History shows that stocks have outperformed bonds and cash over the long term. So, if you are investing for a goal like a retirement that is decades away, it may make sense to have a larger allocation to stocks than someone nearing or in retirement, provided you’re comfortable with the risk (See Viewpoints: Why choose stocks?). One way to help manage the volatility that comes with stocks is to make sure your portfolio is diversified within and among asset classes—so you will still want some bonds for ballast.

But how do those savings choices turn into a retirement “paycheck”?

As a rule of thumb, we assume the average retiree will spend about 85% of his or her final net pay to live comfortably in retirement, as there is no longer a need to save for retirement, and certain work-related costs will go away. Of course, this is not a hard and fast rule, and your percentage could be much higher or lower, depending on your income level, retirement lifestyle choices, and health care needs (Read Viewpoints: What will you spend in retirement?)

To meet your income needs in retirement, you will likely need a mix of guaranteed income and investment growth. We recommend covering essential expenses with guaranteed income like Social Security, pensions, and annuities, and using your investment portfolio for discretionary expenses like travel.

But how do you accumulate enough money before retirement to meet those income goals in retirement? It depends upon the three A’s—the amount, account, and asset allocation choices you make during your working and savings years.

That’s why we built the interactive widget below, to help you experience how different choices along the road to retirement could affect your income stream in retirement. (Note: Although tax rates will vary, for this widget we assume that withdrawals from 401(k)s and IRAs are net of an average 20% income tax, while those from HSAs are tax free.)4

If you fall short of your estimated retirement income goal, don’t panic. Remember, it’s never too late to make adjustments that can lead to better outcomes. Save more, retire later, spend less in retirement, or rethink your asset allocation to help get back on track.

Meet Lily, a super saver

Let’s start with our first hypothetical saver, Lily.5 Lily starts saving when she gets her first job, at age 25; she contributes 12% pretax of her $50,000 salary (deferring 9% plus a 3% employer match) into a 401(k), and continues to defer 12% in a workplace plan throughout her career. We assume her investments grow at an average nominal rate of return of 7% a year (market plus inflation).6 To get such a return, we anticipate Lily will need a significant allocation to stocks in her portfolio.

When Lily retires, at age 67, we assume she will need to spend 85% of her final net pay each year of retirement—approximately $5,220 per month.7 Assuming $1,900 net monthly income from Social Security and no pension plan or other savings, Lily needs her 401(k) to cover spending of around $3,320 a month for what she estimates to be 27 years of retirement. Because of Lily’s strong saving and investing habits, she is on track to be able to spend a total of about $5,730, $510 more than she has targeted, giving her a cushion against worse-than-expected investment returns or other uncertainties.

If Lily’s salary had grown more, or if she had had a break in service, or if her portfolio had returned less, her 401(k) might be insufficient, even with Social Security, to cover 85% of her ending net salary. In that case, she would have been well served by saving even more (or spending less in retirement). Otherwise she may have needed to postpone retirement or work in retirement—or both.

When life gets in the way

What if you weren’t able to save as much as Lily did? Perhaps you were saddled with too much student debt early on, and you started saving for retirement much later than you’d expected, or your health interfered, preventing you from working for a time. On the other hand, what if your life turned out better than you had expected, and your earnings exceeded your expectations?

Below are two “life got in the way” scenarios. In each case, there is a difference between what our hypothetical savers expected to have accumulated for retirement and what they actually ended up with—either a savings gap or a savings surplus.

Meet Harry, the late starter

Harry graduated from college with $50,000 in student debt. In the early years after school, Harry bounced from one job to another and was more focused on adventures and buying and furnishing his home than savings. One thing led to another, and by the time Harry paid off his student loans, he was 35 years old and hadn’t yet started saving for retirement. With no 401(k) or other retirement savings, he needed a catch-up plan.

Let’s assume that, at age 35, Harry starts contributing 12% pretax (deferring 9% and receiving a 3% employer match) of his $75,000 salary to his 401(k) plan. We assume Harry will receive $1,900 net monthly income from Social Security and has no pension plan or other savings. Meanwhile, his career goes well and his salary continues to grow an average 1.5% a year above inflation. His investments also prosper, producing an average return of 7% a year. Still, our widget suggests he would fall $1,670 a month short of his estimated retirement income goal of $6,740 a month over 27 years in retirement. “Delaying saving may come with a high price,” says Sweeney.

So, what would Harry’s options be? He could boost his 401(k) saving to 15% of his salary starting at age 35 and continue doing so throughout his working life. Still, he would fall $860 a month short of his goal after taxes at retirement, according to our estimate. If he adds $2,000 a year to an IRA beginning at 35, the gap shrinks to $270 a month. If he also adds $2,000 a year to an HSA, the gap turns into a surplus of $470 a month. Of course, that assumes Harry doesn’t withdraw any money from his 401(k), IRA, or HSA before he retires, at 67.

This illustrates the power of where you save. By saving in an HSA, Harry would be able to not only save pretax and have his earnings grow without being taxed, he would also have the advantage of tax-free withdrawals on qualified medical expenses in retirement. Adding $2,000 a year to an HSA versus an IRA results in an estimated $140 more in monthly retirement income. Of course, this assumes that Harry does not withdraw any of his HSA money for health care expenses before he retires.

Meet Muriel: Her income has outpaced her dreams

Muriel is 25. Her career has been on a roll. Already she is making $75,000 a year, and her salary is growing at an average 1.5% rate above inflation. Like Lily, Muriel is diligent about saving at work, deferring 12% pretax of her salary in a 401(k)—9% deferral rate plus a 3% company match—and anticipates earning 7% a year on her investments. With Social Security, her workplace savings could generate $7,670 a month, $160 short of her retirement income goal of $7,830.

What are Muriel’s options? Saving just another $500 a year more in an IRA would leave her with a $90-a-month surplus. Or, she could contribute more in her 401(k) or through an HSA. Again, because she is starting early, saving diligently, and investing for growth, Muriel—like Lily—looks to be on track to meet her retirement income goals. If Muriel, Lily, or Harry earn more than the assumed 7% on their investment portfolios, they may be able to retire earlier; if they do worse, they may need to postpone retirement, work part time in retirement, cut spending, or make other adjustments.

Note one difference: Social Security is estimated to make up only about a quarter of Muriel’s retirement paycheck, versus more than a third of Lily’s. As incomes rise, Social Security covers a decreasing percentage of the retirement paycheck. So, the more you earn, the more you need to shoulder responsibility for saving to meet your retirement income needs.

If you are earning more than $150,000 a year, you may need to save beyond your 401(k) or other workplace savings plan, take advantage of 401(k) catch-up contributions, or max out on HSA contributions (if applicable) to meet your retirement income goals. For 2014, 401(k) contributions are limited to $17,500 for investors under age 50 and $23,000 for investors aged 50 and older ($17,500 plus $5,500 for catch-up).

Bottom line

As you can see, building your retirement paycheck is a very individualized process that requires discipline and knowing when to make adjustments if life gets in the way. As you build, let our three A’s—amount, account, and asset allocation—help you get and stay on track to achieve the retirement you imagine.

Learn more

  • Read Viewpoints: Retirement Roadmap.
  • Help create a roadmap toward retirement with our Income Simulator (NetBenefits® login required).
  • Create a retirement income strategy that matches your goals with Retirement Quick Check.
  • Visit one of Fidelity’s 183 Investor Centers or call 1-800- FIDELITY (1-800-343-3548) for a consultation with a Fidelity investment professional.
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1. As a rule of thumb, we suggest that investors not expecting a pension target a 10%-15% savings rate, including employer contributions. Suggested total savings rate range is based on an assumed savings start age of 25, retirement age of 67, an age-appropriate asset allocation, and utilization of tax-deferred savings accounts such as a 401(k).
2. A distribution from a Roth IRA is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase, or death.
3. Investors should consider both a pretax 401(k) and a Roth 401(k). With a Roth 401(k), your contributions and taxes are coming out of your paycheck each pay period. However distributions from a Roth 401(k) are tax free and penalty free, provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase ($10,000 lifetime limit), or die.
4. Not all states treat HSA contributions as tax deductible or HSA withdrawals as tax free. For federal tax purposes, HSA contributions are tax deductible and HSA withdrawals are tax free if used for qualified medical expenses.
5. The baseline hypothetical assumptions for Lily are based on the following: that the individual saves until retirement age 67 and lives through age 93; starting age for saving of 25 and starting salary of $50,000; pretax deferral rate of 9% with 3% employer match; real annual salary growth of 1.5%; retirement spending goal of 85% of final net pay; market growth rates are nominal at 7% (4.5% real return plus 2.5% inflation). Investment return is purely hypothetical and for illustrative purposes only; it is not an expected investment return; deferral rates are assumed to remain constant throughout working careers; no loans or early distributions; 2013 IRS 401(k), IRA, and HSA contribution, catch-up, and compensation limits not strictly applied; 20% effective tax both before retirement and during retirement. The retirement paycheck dollar amount is the assumed real (inflation-adjusted) net dollar amount to be spent annually through age 93.

Social Security benefits determined using Social Security Administration simplified lookup tables based on projected ending salary. Benefits based on normal retirement age and not adjusted for claiming early or delayed benefits. Effective tax rate of 20% applied to 70% of the annual benefit.

Tax-free withdrawal benefits of HSAs to pay for qualified medical expenses are applied, and assume an individual HDHP account (as opposed to a family plan) with an HSA option. Upon distribution, applicable federal, state, and local taxes may be due. Hypothetical tax rate is for illustrative purposes only and is not an estimate of actual effective tax rates an investor may experience. A distribution from a Roth IRA is tax free and penalty free, provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase ($10,000 lifetime limit), or die.
6. The 7% return is nominal and represents market growth inclusive of inflation.
7. Ending pretax salary of $92,100 after 20% effective tax rate results in $73,680 ending net salary. Assuming 85% spending in retirement gives $62,630, divided by 12 gives $5,219 monthly expenses. Note: All results produced in the interactive graphic are in today’s dollars. The 2.5% inflation rate is used only to reduce the nominal market return selected by the user.
Income Simulator and Retirement Quick Check are educational tools.
Past performance is no guarantee of future results.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Your own account may earn more or less than these hypothetical scenarios.
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