An updated wealth creation rule of thumb

You may have heard the rule of thumb that you should save and invest about 10% of your income. I think it originated from the book “The Richest Man in Babylon” by George S. Clason.

I’m often asked if that is before or after tax saving.

More importantly, is it even close to right?

If it was close to being accurate then in Australia the 9% compulsory employer superannuation contributions should get people close enough. Sadly it is widly accepted that the 9% is nowhere near enough.

Last month the Financial Services Council released research by RiceWarner Actuaries that estimated the average retirement savings gap per person was about $88,000. That is the extra amount they need to have an adequate retirement lifestyle.

How much you need to save

If you are currently in your 20s or 30s RiceWarner estimated you’ll need to save and invest (for retirement) approximately an extra 11% per year of your after-tax income, in addition to the 9% employer superannuation.

If you’re already in your 40s you’ll need to save an extra 12% per year after-tax.

If you’re already in your 50s it’s about 15% extra per year.

So really the rule of thumb should actually be that you need to save a total of at least 20%-25% or more (not 10%) of your after-tax income over your entire working life to come close to an adequate retirement lifestyle.

(Note the actual figures in the research are split by gender and 5 year age brackets. For simplicity I have approximated an average. See table 3 on page 6 of the report if your brain wants greater precision.)

Important assumptions

Definition of an adequate retirement lifestyle

The model assumes that you can have an adequate retirement lifestyle if you receive about 62.5% of your gross pre-retirement income. This is estimated to enable you to have about 75% of your pre-retirement expenses. (Assuming you have no debts left in retirement.)

Most people I meet do not want to decrease their lifestyle in retirement. So if that includes you then you need to consider that you may need to:

  • Save a higher percentage;
  • Invest more aggressively;
  • Do a bit of both

If the prospect of saving that much and/or investing aggressively scares you then meet with a great financial planner who can guide on a smart wealth creation strategy that suits you.

You may live longer

One of the assumptions is that you need the retirement lifestyle under the average life expectancy. The reality is that half of the population live past that point. So if you rely on this updated rule of thumb be prepared to live on just the Age Pension past your life expectancy.

The better way to calculate how much you need to save

Rules of thumb can be nice short cuts but when it comes to money there is no substitute for proper planning and purposeful action.

The best way to work out how much you need to save is to:

  1. Define the lifestyle choices you’d like to have in retirement
  2. Estimate how much those choices would cost right now
  3. Define when you want to make work optional (“retire”)
  4. Define how long you want that lifestyle to last (age 83, 90, 100?)
  5. Calculate what lump-sum wealth you’d need at retirement to fund that lifestyle for that long
  6. Calculate the annual savings you need to make from now until retirement in order to accumulate that wealth

There are some calculators available for free on the internet to help you do this calculation yourself.  View a list here.

But if you are not naturally analytical then I recommend you partner with a financial planner to guide you on how much you need to save and the best way to invest that money.

Author: Matt Hern

Certified Financial Planner professional, Matt Hern has three times been awarded as one of Australia's Top 50 Financial Planners by The Australian Financial Review Smart Investor. He is passionate about guiding you on the right financial choices to achieve what you really want. Matt Hern is an Authorised Representative of Charter Financial Planning Limited AFSL 234665. All information is general advice only.

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