I recently interviewed Kimberly Palmer, author of “Generation Earn: The Young Professional’s Guide to Spending, Investing, and Giving Back.”
Palmer recommends young professionals save at least 25 percent of their pretax income as they earn it. She adds that up-and-coming feds should take advantage of their retirement benefits, particularly the Thrift Savings Plan.
I advocate the TSP as the best retirement investment vehicle available anywhere. Its low expenses, efficient design and simplicity make it better than any other defined contribution retirement plan I know of. I agree with Palmer’s advice to maximize your TSP contributions. Generally, I prefer to see my clients save to the TSP first, then to a tax-deductible traditional IRA, then to a Roth IRA and then to a taxable account, to the extent that each of these options is available.
But I am intrigued by Palmer’s rather aggressive recommendation that young professionals save at least 25 percent of their pretax income. This is a significantly higher savings rate than is typically realized, or even targeted, by most people. Palmer points out that, in addition to retirement, her recommended savings rate includes allowances for other goals, such as emergencies and travel.
I’d like to focus on the savings rate required to fund income replacement in retirement. I’ve run some analyses aimed at determining the savings rates required to fund full — 100 percent — replacement of your pre-retirement income from your TSP account. In my analysis, I assumed that the TSP money was invested and annually rebalanced using an allocation of 55 percent in the C Fund, 25 percent in the S Fund, 10 percent in the I Fund, 5 percent in the G Fund and 5 percent in the F Fund before retirement and a more conservative 40 percent in the C Fund, 15 percent in the S Fund, 5 percent in the I Fund, 15 percent in the G Fund and 25 percent in the F Fund during retirement.
- The earlier you start saving, the less you’ll have to save. For example, I estimate that if you start saving at age 25 and want to retire at age 67, you’ll need to save about 10 percent of your gross income in the TSP to fund a plan that includes lifetime withdrawals equal to your pre-retirement gross income. Wait until you’re 35 to start saving and the required savings rate rises to 20 percent.
- The earlier you retire, the more you’ll have to save. For example, if the 25-year-old saver above retires at age 57, she’ll need to save about 25 percent of her gross income to fund full income replacement from her TSP account in retirement.
The preceding estimates do not take into account any Social Security, annuity or other retirement income. If you assume that those sources of income will be there when you retire, as promised today, my analysis shows they may support, on their own, full income replacement for career employees up to General Schedule Grade 9 who wait until their full Social Security retirement age to retire. In other words, as they are configured today, Social Security and the Federal Employees Retirement System, after your 40 years of service, will replace close to 100 percent of your pre-retirement income as long as your pre-retirement pay doesn’t exceed about $50,000 per year, in today’s dollars.
As your pay rises beyond that level, the FERS component of your retirement income will rise accordingly, but the Social Security component will lag behind, and you’ll have to make up the difference out of your savings. This means that, if you’re expecting Social Security to replace a portion of your pre-retirement income, the more you earn, the more — as a percentage of your gross pay — you’ll have to save.
The amount you’ll need to save for retirement varies considerably according to the assumptions used in analysis. It is possible to determine your unique required savings rate, but if you’re not up to the task, Palmer’s 25 percent recommendation seems like a safe bet for most young feds.