The conventional wisdom around retirement planning says to start investing a percentage of your income when you’re young — at least 10% — and when you’re not so young, you should have enough of a nest egg to live on for the rest of your life. For example, if you’re 25 years old, invest $300 per month for 40 years, generate an 8% average annual return, and you will end up with nearly $1 million dollars by age 65.
However, according to financial advisor Michael Kitces, there are two potential problems with that mindset.
First, it assumes your portfolio will generate that 8% average annual return throughout your 40-year time horizon. Sure, you realize that the returns will fluctuate year by year, but you’re counting on that eight percent average to hold up throughout the 40 years.
“The caveat,” Kitces says, “is that at age 55 you’re not even up to $450,000 yet! In other words, ’save for the long run and let compounding work for you’ could also be characterized as ’save for decades, then quickly double your money and retire.’ Of course, when you look at it that way, it seems a whole lot riskier to count on your money doubling in the last 8 to 10 years.”
Setting a finish line
The other problem is more of a “missed opportunity” that could resolve the first issue.
Kitces points out that while a rising income means that investing a set percentage of income will translate into more dollars going into savings each year, it also means that what’s left over leaves room for some serious lifestyle inflation. And that fixed savings rate may not be enough to maintain that inflated lifestyle in retirement.
His solution is to stop “blindly saving a [set] percentage of your income” and to make sure that “as your income rises through your working years, your lifestyle doesn’t creep quite as high along the way.”
Of course, there are unavoidable ways that expenses increase over time, whether through general inflation or family growth. Still, his point about managing “lifestyle inflation” is a good one.
In some circles, people talk about “setting a financial finish line” or “driving a stake” in their lifestyle. Both phrases refer to a similar idea — deciding that, beyond a certain point, if income increases, lifestyle will not increase, or at least not to the same degree. The gap between a capped lifestyle and any further increases in income can then be used for additional saving or giving.
Has setting a pre-retirement financial finish line been part of your retirement planning? If so, how has it helped?
