Retirement savings: Benefits of boosting contributions

At risk of stating the obvious: Boosting one’s savings rate is among the best ways to improve a household’s retirement prospects. Doing so increases the size of the financial war chest one can deploy in old age.

But there’s another, somewhat hidden benefit to saving a larger share of income, according to financial advisors — it simultaneously pushes households to live on less money, thereby reducing the amount of money they’ll ultimately need to fund their lifestyle in retirement. It may even help reduce the age at which someone is financially able to retire.

“A higher savings rate doesn’t just build the portfolio faster. It also lowers the amount you need to retire,” Fran Walsh, co-founder of Opulus, a financial advisory firm based in Doylestown, Pennsylvania, wrote in a recent post.

“Because if you’re living on less, you need less to sustain that life indefinitely,” he wrote.

Walsh provided an example to illustrate the concept.

Consider two households: Each earns $250,000, starts saving at age 35, and gets an assumed 8% annual rate of return.

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

Next, we use the so-called rule of 25 to determine the households’ respective savings targets. This framework uses household spending to approximate the size of an adequate nest egg, by multiplying its annual spending by 25.

Household A, which saves less and spends $225,000 a year, would need about $5.6 million in retirement savings to continue to fund its lifestyle, according to the rule of 25.

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

The result is a reduction in the “finish line,” or retirement age, Walsh wrote.

The former household may be able to retire at age 73, while the latter may do so at age 57, according to his projections.

The calculation doesn’t account for factors like Social Security, pension income, taxes, inflation or investment fees, each of which would affect the actual outcome, according to Walsh.

“But the directional point holds: savings rate is doing far more work than most people realize,” he wrote.

The question of how much to save is a perennial headache for many households.

A household’s savings rate is often subjective, guided by factors like desired retirement age and other financial goals — as well as certain unknowable details like how long one is going to live.

But there are rules of thumb that can serve as a general starting point.

For example, some financial planners recommend the so-called “50-30-20 rule” to develop a budget for spending and saving.

The numbers refer to the share of take-home pay allocated to different areas of your life: Half of a paycheck for necessities like food and housing; 30% to discretionary spending like entertainment and travel; and 20% to saving and paying down debt.

Walsh recommends saving at least 20% of income.

“If you can do that for 10, 20, 30 years, you’re going to be in really good shape,” he told CNBC in an interview.

Often, households may start out by saving an adequate amount for retirement but inadvertently fall behind over the years due to “lifestyle creep.”

In other words, people get raises and increase their spending on things like bigger houses and fancier cars — but don’t also adjust their savings upwards, advisors said.

For example, a retirement saver who earns $100,000 a year and invests $20,000 annually would save 20% of their income. If their salary were to grow to $110,000 and the $20,000 sum doesn’t change, that savings rate falls to about 18%; at a $150,000 salary, it’s 13%.

It’s much easier for a young saver to build the habit early, so they don’t get overly accustomed to spending tendencies that become harder to unwind decades later, advisors said.

People looking to cut back on their expenses should do so gradually, rather than making drastic shifts that may be unsustainable, said Uziel Gomez, a certified financial planner and founder of Primeros Financial, based in Los Angeles.

“It has to be something very realistic that you’re able to do,” said Gomez, a member of CNBC’s Financial Advisor Council.

“It’s like a diet: You want to do it incrementally, not all at once,” he said. “When you lose weight, you do it slowly and surely, so your body adjusts to the new way of eating.”

Starting small and throttling back incrementally helps people stick with the new plan over time, he said.

For example, Gomez said he has clients who spend $500 a month on Amazon purchases. Rather than decrease that spending to perhaps $100 a month all at once, maybe first decrease it to $400, he said.

Dining out, including takeout meals, and shopping are two of the categories where Gomez said he typically sees wiggle room for people to reduce outlays.

“There’s no universal right answer for what the savings rate should be,” Walsh wrote. “What matters is that it’s intentional — set in advance, not whatever’s left over after everything else.”