Retirement funds: Benefits of increasing contributions

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

But there’s another hidden benefit to saving a large portion of your income, according to financial advisors — at the same time forcing families to live on less, thereby reducing the amount of money they’ll ultimately need to support their lifestyle in retirement. It may also help to reduce the age at which a person is financially able to retire.

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

“Because if you live with less, you need less to sustain that life forever,” he wrote.

Walsh gave an example to illustrate the concept.

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

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

Next, we use the so-called rule of 25 to determine household savings goals. This framework uses household income to estimate the size of an adequate nest egg, by multiplying its annual consumption by 25.

Family A, which saves less and spends $225,000 a year, will need about $5.6 million in retirement savings to continue to support their lifestyle, according to Rule 25.

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

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

The former family may be able to retire at the age of 73, while the former may retire at the age of 57, in his opinion.

The figure does not account for factors such as social security, pension income, taxes, inflation or investment fees, each of which can affect the actual result, according to Walsh.

“But the guiding principle is there: the savings rate does a lot more work than most people realize,” he wrote.

The question of how much to save is a constant headache for many families.

A home’s savings rate is often subjective, guided by factors such as desired retirement age and other financial goals – as well as some unknown details such as how long a person will live.

But 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” to develop a budget for spending and saving.

The numbers indicate the portion of take-home pay that is allocated to different areas of your life: Part of the pay for necessities such as food and housing; 30% on discretionary spending such as entertainment and travel; and 20% to save and pay off debts.

Walsh recommends saving at least 20% of your 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 times, households may start out with enough savings for retirement but inadvertently fall behind over the years due to “lifestyle.”

In other words, people are getting promoted and increasing their spending on things like big houses and luxury cars – but not adjusting their savings too much, the advisers say.

For example, a retirement saver who earns $100,000 a year and invests $20,000 a year can save 20% of his income. If their income were to increase to $110,000 and the total $20,000 remained the same, that savings rate drops to about 18%; for a salary of $150,000, 13%.

It’s much easier for a young frugal person to develop the habit early, so they don’t become overly accustomed to spending habits that become difficult to break decades later, advisers say.

People who want to reduce their spending should do it gradually, rather than making big shifts that may not last, says Uziel Gomez, a certified financial planner and founder of Primeros Financial, based in Los Angeles.

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

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

Starting small and going back a little helps people stick with a new plan over time, he said.

For example, Gomez said he has customers who spend $500 a month on Amazon purchases. Instead of reducing that usage to maybe $100 a month all at once, maybe reduce it first to $400, he said.

Eating out, which includes takeout, and shopping are two categories where Gomez said she often sees room for flexibility for people to cut back on going out.

“There is no universally correct answer to what the savings rate should be,” Walsh writes. “The important thing is that it’s deliberate – set in advance, not anything left behind by everything else.”