Retirement: How much to save

NEW YORK (Money) -- Question: I often see people recommend that you save 10 percent of your salary for retirement. Does that 10 percent include any employer matching funds? Or should you be saving 10 percent on your own aside from anything additional your employer may be adding to your 401(k)? - Mike, Lake Villa, Illinois

Answer: Like most rules of thumb, the "save 10 percent of your salary for retirement" doesn't get into details. It's not a formula based on an underlying economic truth. It's really just one of those bromides that's been repeated so often that it's taken on a life of its own.

So while saving 10 percent of your salary is better than saving less than that amount, this rule doesn't make up a serious retirement strategy. After all, even aside from the question you raise about whether the 10 percent includes employer matching funds, there are plenty of other issues this rule doesn't address that can dramatically affect your retirement security.

A quick example will show you want I mean.

Let's say you're 25, earn $40,000 a year and immediately start socking away 10 percent of salary into a 401(k) account. And just for argument's sake, let's say you keep this up for 40 years and that, over that time, you receive annual salary increases of 3 percent and earn an 8 percent annual return on your savings.

Well, in that case, at age 65, you would have a 401(k) worth just over $1.5 million. Assuming an initial withdrawal of 4 percent of your account's value - an amount that would allow you to increase subsequent annual withdrawals for inflation to maintain purchasing power and still have a reasonable assurance your nest egg will last 30 or more years - that would give you just under $62,000 from your 401(k) the first year of retirement.

That would be enough to replace almost half of your pre-retirement salary, which, with 3 percent annual raises, would have grown to about $127,000 by age 65. Throw in Social Security and you've probably got enough to live, if not lavishly, at least comfortably in retirement.

But there are a lot of assumptions here, all of which can change. What if instead of starting at 25, you didn't begin saving until you were 35? Well, if you still saved 10 percent, your portfolio's value would grow only to $900,000, giving you an initial draw of about $34,000, allowing you to replace less than 30 percent of your pre-retirement salary. If you didn't get started until you were 45, your portfolio would only be large enough to replace about 15 percent of your pre-retirement paycheck.

And what if instead of earning 8 percent a year on your investments, you earned 7 percent? Well, even if you still got that early start at age 25, your portfolio would be worth $1.2 million instead of more than $1.5 million, throwing off about $49,000 rather than $62,000, replacing just under 40 percent of your pre-retirement salary instead of half.

I should add that even these examples are incredibly imprecise for a number of reasons. For one thing, they assume you'll earn that 8 percent or 7 percent investment return year in and year out like clockwork. In reality, when you're investing in stock and bond mutual funds, your returns will jump around considerably from year to year, and that will affect the eventual size of your 401(k)'s value.

And speaking of reality, what's the likelihood that you'll actually contribute 10 percent - or any amount for that matter - to your 401(k) every single year for 20, 30 or 40 years. Or that you'll get a 3 percent raise every single year? In the real world, there may be times when your salary remains flat or you miss contributing for several months or longer because you're laid off or you switch jobs or your economic circumstances require you to cut back your 401(k) contributions or maybe even suspend them entirely.

All of which is to say that if you're looking to create a real strategy for achieving retirement security, adopting the 10 percent rule leaves a huge margin of error. You could be on track to a comfortable retirement - or you could find yourself living a meager existence in your dotage.

That said, however, I wouldn't discourage someone from using the 10 percent rule of thumb as a first step. If nothing else, this is a quick way to get into the habit of regular saving, which is the single most important factor in planning for retirement.

But since 10 percent likely isn't adequate unless you get a very early start or believe you can count on other generous company perks - like a traditional check-a-month pension or employer-paid retiree health care, both of which are becoming increasingly rare - then I think it's a good idea to at least try to raise your target to 15 percent.

As for employer matching funds, I would not consider them part of the 10 percent or 15 percent or whatever percentage you save on your own.

In other words, you should try to do 10 percent or 15 percent or more even if your employer is also kicking in dough. Why? Well, for one thing, you may not be able to count on that match throughout your career. If you count employer funds in your savings target and then move to a company that doesn't give a match, you would have to ramp up your savings to compensate.

That would require you to scale back a lifestyle you've become accustomed to, which is difficult. Chances are you wouldn't save more, and you would begin falling behind.

Besides, I don't think that getting a generous employer match means that many people will end up saving way too much. In my experience, the opposite - saving too little - is the bigger risk for most people. All in all, I'd rather err on the side of having a larger nest egg than a smaller one.

One final note. The only real way to tell if you're actually headed toward a secure retirement is to do a more comprehensive analysis that takes into account such factors as how much you already have saved, how much you're saving on a regular basis, how your money is invested and then forecasts a nest egg you're likely to have and how much annual income you can reasonably draw from it in retirement.

You can do that sort of analysis at the Retirement Planner calculator on our site or, if you prefer, you can hire a financial planner to do the number-crunching for you. Of course, the financial markets and your personal situation can change over time, so it's good to do this exercise again every couple of years to assure you're still on track. If you're not, you can make adjustments like saving more, investing differently or even postponing your retirement.

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