Saving for retirement: Benefits of increasing contributions

At the risk of stating the obvious, increasing your savings rate is one of the best ways to improve your household’s retirement prospects. Doing so will increase the size of your funds that you can deploy in retirement.

But financial advisors say there’s another hidden benefit to saving a higher percentage of your income. It also encourages households to live with less money, thereby reducing the amount they ultimately need to fund their retirement years. It may also help lower the age at which people can financially retire.

“A higher savings rate not only helps you build a portfolio faster, it also lowers the amount of money you need to retire,” Fran Walsh, co-founder of Doylestown, Pennsylvania-based financial advisory firm Opulus, wrote in a recent post.

“Because if you’re living on less money, you need less to sustain that lifestyle indefinitely,” he writes.

Mr. Walsh provided an example to explain the concept.

Consider two households. Each household has an income of $250,000, starts saving at age 35, and assumes an annual rate of return of 8%.

Household A saves 10%, or $25,000 per year. Household B saves 30%, or $75,000 per year.

The so-called Rule of 25 is then used to determine each household’s savings goals. This framework uses household expenses to approximate the appropriate nest egg size by multiplying annual expenses by 25.

Household A, with low savings and annual expenses of $225,000, would need approximately $5.6 million in retirement savings to remain financially viable, according to the Rule of 25.

Household B, who saves more and spends $175,000 a year, would need about $4.4 million.

As a result, the “finish line” or retirement age will be lowered, Walsh wrote.

According to his predictions, the former group could potentially retire at age 73, while the latter group could retire at age 57.

Walsh said the calculations do not take into account factors such as Social Security, pension income, taxes, inflation and investment fees, each of which can affect actual results.

“But the directional point holds true: Savings rates do much more than most people realize,” he wrote.

The question of how much to save is a perennial struggle for many families.

A household’s savings rate is often subjective and depends on factors such as desired retirement age and other financial goals, as well as certain unknown details such as life expectancy.

However, there are some rules of thumb that can serve as a general starting point.

For example, some financial planners recommend the so-called “50-30-20 rule” for budgeting your spending and savings.

This number refers to the percentage of your take-home pay that is allocated to different areas of your life. Half of your salary for necessities such as food and shelter. 30% for discretionary expenses such as entertainment and travel. 20% goes toward savings and debt repayments.

Walsh recommends saving at least 20% of your income.

“If we can do that for 10, 20, 30 years, we’ll be in really good shape,” he said in an interview with CNBC.

Households often start by saving an appropriate amount for retirement, but can end up inadvertently neglecting to save over the years due to “lifestyle frenzy.”

In other words, people get raises and spend more on things like bigger homes and luxury cars, without adjusting their savings upwards, advisers say.

For example, a retirement saver who earns $100,000 a year and invests $20,000 a year would save 20% of his income. If their salary increases to $110,000 and the $20,000 amount remains the same, their savings rate drops to about 18%. For a $150,000 salary, it’s 13%.

Advisers say it’s much easier for young savers to develop the habit early and avoid becoming overly accustomed to spending habits that are difficult to undo decades later.

People looking to cut their expenses should do so gradually, rather than making drastic changes that may become unsustainable, says Uziel Gomez, a certified financial planner and founder of Los Angeles-based Primeros Financial.

“It has to be something very real that can be done,” said Gomez, a member of CNBC’s Financial Advisor Council.

“It’s like a diet; you have to do it in stages, not all at once,” he said. “When you lose weight, you lose weight slowly and steadily so your body adjusts to the new way of eating.”

Starting small and gradually slowing down will make it easier for people to stick to the new plan over time, he said.

For example, Gomez said he has customers who spend $500 a month shopping on Amazon. Instead of reducing your spending to $100 a month all at once, you might want to reduce your spending to $400 a month first, he said.

Eating out, including takeout, and shopping are two categories where Gomez typically thinks people have room to cut back on spending, Gomez said.

“There is no universally correct answer to what your savings rate should be,” Walsh writes. “The important thing is that it’s intentional. It’s something that’s set in advance and not something that’s left over after you’ve done everything else.”