Laura Rowley Money & Happiness

American novelist John Dos Passos once wrote that "Apathy is one of the characteristic responses of any living organism when it is subjected to stimuli too intense or too complicated to cope with."

He wasn't referring to the modern dilemma of saving for retirement, of course, but his words capture the situation perfectly. Confronted with the intensity of saving for our golden years and the complications of investing, we procrastinate.

DIY Retirement Planning

No wonder. In a defined pension plan, where an employer guarantees workers an income during retirement, the company hires actuaries and pension consultants to figure out how much to put away for its employees' retirement. But if you're among the majority of workers without a traditional pension, you've been promoted to actuary and pension consultant without any of the training necessary to do the analysis.

That may be at least one reason why nearly half of American households aren't saving at all, and two-thirds aren't saving enough to retire adequately, according to new research by the Securities Industry Association.

What you need is a simplified process that addresses these basic retirement saving questions: How much should I save? How much should my investments earn? Am I on track?

One of the niftiest methods I've seen comes from Charles J. Farrell, a financial consultant and former tax attorney in Medina, Ohio. His bottom line? For a comfortable retirement, you need to save 12 percent of your annual pay starting at age 30 and pay off all your debts by age 65.

A Simple Calculation

Here's how it works. Farrell assumes that you'll withdraw no more than 5 percent of your retirement portfolio per year once you stop working. At that distribution rate, your savings will provide 60 percent of your preretirement income. Social Security will provide another 20 to 25 percent, for a total of 80 to 85 percent.

(This is close to what you were living on while working, since theoretically you would have been saving 12 percent of your income per year -- something you can stop doing in retirement.)

As an example, say Alice earns $50,000 a year. She saves 12 times her pay, or $600,000, by age 65. In retirement, her annual income is comprised of:

• 5 percent annual savings withdrawal (5 percent of $600,000): $30,000
  
• 20 to 25 percent Social Security: $10,000 to $12,500
  
• Total: $40,000 to $42,500
  

Farrell assumes that your savings will earn a 5 percent real rate of return (after inflation), and that your portfolio is invested 70/30 or 60/40 percent in stocks/bonds, depending on your age. At a 5 percent withdrawal rate, studies show, your money should last for 30 years in most cases. (For more on Farrell's method, see his article "Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement" in the Journal of Financial Planning.)

Sooner Is Better

Farrell has created a series of retirement ratios that indicate what your savings and debt levels should be at specific ages (see the chart the end of this column). When I calculated the ratios for my family, we were comfortably above the savings-to-income ratio -- but had way too much debt.

This seemed odd, since the only debt we carry is our low-interest mortgage, and we're on track to pay that off right at retirement. But Farrell admits that oversized housing prices on the coasts can skew the debt-to-income ratio. "The goal is to keep debt at reasonable levels based on income," he explains, "because otherwise you won't have enough cash flow to save at the recommended level of pay."

In other words, aim first to meet the savings-to-income ratio while steadily paying off debt, with the goal of being debt-free in retirement.

Farrell's scenario assumes that people won't start saving for retirement until age 30, but it's best to start socking away 12 percent of your pay right out of the gate. The longer your money is invested, the better the chances for significant positive growth -- and the better your ability to make up for lost time later in life.

Keep on Track and Stay Put

Using Farrell's ratios to track your progress may also help prevent the lifestyle ramp-up that typically occurs in your 40s. That's when people often succumb to the temptation to trade up to a bigger home or build pricey additions. "People can qualify for mortgages at numbers that are much bigger than they could before," Farrell explains. "It's nice to put money in your house, but you're kidding yourself if you think it's a big investment."

Few people can blow a small fortune on a massive home addition and save 12 percent of income at the same time, unless they plan a dramatic downsize during retirement. Interestingly, Farrell does not include home equity in his savings formula, because in his experience as a planner he sees few retirees who actually sell their homes and move to cheaper digs.

"If I'm living in Washington, D.C., plan to move to North Carolina, and pull out $300,000 in equity, I can count that in the savings," he says. "But be honest with yourself about what your plans are. It's better to have your house paid off and not rely on moving."

Whether you plan to stay put or relocate, ditch the mortgage by age 65 -- this will give you the flexibility to manage when the markets sink. "Your ability to draw down on your assets is driven by the financial markets," Farrell notes. "We've had six difficult years in the stock market. The bond market has been very tight, there's not a lot of income there. Even if your capital is a pretty good size, there may be years you have to cut back on distributions."

If You Can't Hit the Target

If you're nowhere near the ideal savings-to-income ratio and retirement is on the horizon, don't despair. You may need to make adjustments -- increase your savings immediately, work longer, or downsize your lifestyle during retirement. Saving 10 times your pay will reproduce 50 percent of your preretirement income, and eight times will produce 40 percent.

As for investing, one way to simplify the decision-making process is to choose a target-strategy or life-cycle fund, such as T. Rowe Price Retirement Funds or Vanguard Target Retirement Funds. These funds offer a diversified basket of stocks and bonds that become more conservative as you near your retirement date -- a good choice for someone whose response to retirement planning has been apathy.

Calculate Your Retirement Ratio

Find your age on the following chart. If there are two workers less than five years apart in your household, use an average of their ages; if they are more than five years apart, use each person's income and half of the total household savings and debt.

Multiply your income times the first number (savings-to-income): This is how much you should have saved. Then multiply your income times the second number (debt-to-income): You should have no more than this amount in debt.

Example: A 35-year-old who earns $50,000 should have at least $45,000 in savings and no more than $75,000 in debt.

Source: Charles J. Farrell, J.D., LL.M.