What Retirement Savings Rate Should Millennials Shoot For?

You may have heard that a recent Nerdwallet study found that millennials may need to save upwards of 22% of salary throughout their careers if they hope to have a secure retirement. Yikes! That's almost 50% more than the 15% target many retirement experts suggest, and nearly four times the median 6% that a 2015 Nerdwallet report says young workers are currently saving. Which raises a serious question: Is 22% a realistic target for millennials to shoot for, especially considering that many of them are already struggling with housing costs and student loan debt?

To answer that question, you first need to understand how Nerdwallet arrived at that 22% figure. Essentially, the study attempts to determine the percentage of income that a millennial—in this case, a hypothetical 25-year-old who earns $40,000 a year and gets 2% annual pay raises—would need to save each year in order to retire at age 67 on 80% of pre-retirement income.

As you'd expect, the savings number you come up with depends to a large extent on investment returns. Nerdwallet columnist and study author Jonathan Todd calculated that if you assume a real, or inflation-adjusted, return of 7% a year—the average for the stock market since 1950—a savings rate of 13% would be sufficient to accumulate a nest egg of just under $1.7 million by age 67. Assume an initial withdrawal of 4% that's subsequently adjusted for inflation, and you end up with a real, or inflation-adjusted, retirement income of roughly $68,000 a year, or about 80% of that 25-year-old's average income for the 10 years leading up to retirement.

Todd notes, however, that a number of investment analysts predict that slow economic growth could drag down real returns by two percentage points a year in the decades ahead. And if you assume that the 25-year-old earns a 5% annual real return on savings instead of 7%, then the savings rate required to build the $1.7 million nest egg jumps from 13% a year to...you guessed it, 22%.

I don't doubt the calculations. I got very similar results running the numbers on my own. But if you're like me, you may have noticed that there's one important element missing here: Social Security income. The reason is that Nerdwallet didn't include any. When I asked Todd why Social Security, which represents a significant portion of retirement income for the vast majority of Americans, was excluded from the analysis, he told me that "most millennials don't expect to get any Social Security." He cited a Pew Research Center survey that found 51% of millennials believe they'll receive nothing from Social Security when they retire.

Given Social Security's well-known funding issues, I can understand why many young workers have doubts about the program. Still, to calculate a savings rate that factors in no Social Security benefit at all and thus effectively assumes that today's young workers will have to fund their retirement entirely from personal savings strikes me as a bit, well, extreme.

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People can argue about how much retirees in the future may end up getting. But a 2015 Congressional Budget Office report estimates that even assuming the Social Security trust fund runs dry, today's highest-income younger workers would still receive roughly 20% of their pre-retirement income in benefits from payroll taxes that would still flow into the system. Social Security would actually replace a higher percentage of pre-retirement income for most workers, as Social Security's replacement rate increases at lower levels of career earnings.

So even if you assume our hypothetical 25-year-old will collect Social Security equal to only 20% of pre-retirement income, that means that personal savings must replace just 60% of average earnings in the years prior to retirement rather than 80%. By my calculations, saving 15% a year would give the 25-year-old in the study a nest egg at age 67 that, combined with Social Security, would be large enough to replace just under 75% of pre-retirement income. Throw in some income from a reverse mortgage or a few years of part-time work in retirement, and you're pretty darn close to hitting that 80% target with a 15% savings rate instead of 22%, even if investment returns do drop from 7% to 5% a year.

To be fair, I should note that in the real world outside of spreadsheets it's virtually impossible for anyone to predict precisely how much you need to save for retirement. There are too many uncertainties: how much you earn over the course of your career, how the financial markets perform, whether you miss a few years of saving due to bouts of unemployment, the possibility you may have to dip into savings to deal with financial setbacks. Any savings recommendation is going to be an approximation at best.

That said, I think that calculating a savings rate that excludes Social Security entirely may give young workers the impression they've got to save at a pace that's probably unachievable for most of them. Maybe that will spur some people to redouble (or re-triple) their savings effort. But faced with such a daunting hurdle, some young workers may figure it's hopeless and save very little or forgo saving for retirement at all.

If you're starting out and can somehow afford to save 22% a year and still live an acceptable lifestyle, hey, go for it. Far be it from me to stand in the way of someone who wants to save like a demon for retirement. But I doubt that very many young people will be able to save that much and still have enough left for things like paying off student loans, raising a family and buying a home. I think a more reasonable strategy is to shoot for a target of 15% or so—a figure that's cited in a Boston College Center For Retirement Research study—and if you can't save that much right off the bat (which is also pretty likely), try to work up to it. Better yet, find a savings rate that makes sense given your particular situation. You'll find a number of tools and calculator that can help you do that in the Saving For Retirement section of my Retirement Toolbox.

Finally, while I don't agree with that 22% figure, I'm totally on board with the tips laid out at the end of Nerdwallet's study—start saving early, take advantage of tax benefits and employer matches, invest in stocks and bonds, hold the line on investment costs—and especially this piece of advice: "Even if you can't set aside the income required to reach your future goal, every dollar of retirement savings counts."

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.