How Much You Need to Retire
One of the biggest challenges I see with finance is that there are so many opinions, theories, concepts, strategies, etc. that distract many of us from a few basic principles that can significantly enrich us financially.
Basics like, spend less than you make, use your employer-sponsored retirement plan, avoid debt on depreciating assets, use diversification in your investing, and give generously are all concepts that will benefit us greatly if we practice them well enough.
Eventually though, as we move beyond covering these basic monetary disciplines, we will begin to accumulate and save for our future, whatever we hope it looks like.
More specifically, one day we will all need to answer the question, “How much do I need?”
The answer to that is unique to all of us and that’s primarily why it’s such a challenge to address.
In this post, I’m going to walk you through a basic step-by-step path to calculating how much you need to fund your retirement. From here on out, I will refer to this amount as “your number”, so when you see those words just know that’s the goal we’re aiming for.
Also, as I talk about your number, remember that this too is an approximation.
Even if you go to great lengths to calculate every nickel and dime you plan to spend in retirement, life will bring unexpected changes, making obsolescence of even the most thoroughly conceived plans.
I suggest learning how to measure and adjust your financial plans frequently as you age. The process I’m about to outline is a handy way to do that.
Step 1: Calculate Your Current Monthly Expenses
There are a seemingly endless number of retirement calculators available on the internet these days.
Some are good, some are not.
If a given retirement calculator doesn’t start by challenging you to identify the amount of money you plan to spend in the future, then you shouldn’t trust it to accurately provide a forecast of your number.
Many calculators make assumptions based on your current income, most often guessing you will spend 80% of whatever that amount is annually when you enter retirement.
I suppose it’s not a bad guess, but it’s still a guess.
For more certainty, you need to project your actual spending needs in retirement.
I’m not saying this will be an easy task, but it’s necessary if you want an accurate goal.
This will require further refinement which we’ll get to in a second, but for now we just want a baseline.
Hopefully, you already keep a budget and have a relatively clear picture of just how much your monthly expenses are.
If not, now is a good time to put one together. If you need help, use your bank statements and credit card statements to refresh your memory.
Step 2: Cut Out Expenses You Won’t Have in the Future
Next, remove any expenses you don’t think you’ll have when you reach retirement.
Two of the more common expiring expenditures I see are a paid-off mortgage and reduced living expenses after the kids have flown the nest.
But there could be other debts you’ll have paid off or expenses related to work that won’t be a burden any longer.
Again, it can be a challenge to think of everything and project it, but the more accurate you can be, the closer your number will be to what you really need.
Step 3: Add New Expenses
Finally, increase your budgeted expenses for any new endeavors you’ll have down the road.
For example, it’s not uncommon at all for new retirees to travel extensively.
Many people buy vacation property or build a space to engage in a new hobby.
The fact is a lot of people spend more in retirement, not less. There’s absolutely nothing wrong with that unless you fail to account for it and don’t have enough money when you retire.
Also, be sure to account for any increased medical costs here. This is especially true for you early retirees.
If you retire before age 65, you won’t be eligible for Medicare yet which means you’ll be buying health coverage on your own.
As you probably know, health insurance can be extremely expensive. Don’t overlook it!
Step 4: Annualize This Amount
If you haven’t already done so, you should annualize this monthly amount and turn it into an annual amount.
It’s as easy as multiplying by 12.
The reason I suggest this is because, in the financial world, progress is most often measured in annual terms, specifically rates of return.
You’ll also calculate and pay taxes on an annual basis, among other things.
Since most of the communication, examples, and other measures of progress are typically shared in annualized units, you’ll find the journey easier if you just go with this flow.
Step 5: Multiply by 25 (or Divide by 4%)
After giving you an earful about the importance of accuracy in the leading section of this post, I’m now going to suggest that you begin making some approximations.
The fact is you can’t create a forecast without making some assumptions.
The good news is the rule of thumb I’m about to suggest has the backing of PhDs and years of use in the financial services industry.
The 4% Rule is the product of a study by a trio of professors at Trinity University in the late 1990s which more or less stated that, based on historical data, investors with a portfolio holding a mix of stocks and bonds who began withdrawing at the rate of 3% to 4% annually (increasing with CPI thereafter) were “extremely unlikely” to exhaust the funds in the portfolio within a 30 year period.
In other words, for a 30-year retirement, 4% is considered a safe amount to withdraw from one’s retirement nest egg annually.
And, now that you’ve navigated steps one through four above, you know how much 4% of your portfolio should be.
To calculate the total portfolio value necessary to support a 4% annual withdrawal rate, simply divide your annual forecasted spending amount by 4% or, even more simply, multiply your forecasted spending by 25 since it is the reciprocal of 4%.
For example, if you believe you’ll need $100,000 available each year to fund your retirement, then multiply $100,000 by 25 to arrive at a total of $2,500,000.
Want to spend $130,000 per year? $130k x 25 = $3,250,000
Step 6: Adjust for Your Retirement Horizon
From the preceding section, you should note that the origins of the 4% rule were based on a 30-year retirement.
If you retire in your 60s or later, then a 30-year retirement is probably a sufficient estimate.
But what if you retire in your 50s or even earlier? Your retirement could last 40 years or more.
As a result, you should adjust your safe withdrawal rate expectations accordingly, so you don’t run out of money before you die.
If you anticipate retiring in your 50s, I would use 3% (reciprocal = 33.3) as a safe withdrawal rate.
If you plan to retire in your 40s or earlier, go with 2% (reciprocal = 50).
These safe withdrawal rates are a bit on the conservative side, but I’d prefer to play it safe and retire with too much than not enough.
Other Notes
In the opening, I stated that this process will provide an approximation of your number and I’d like to reiterate that now.
Even the most sophisticated financial plans will require adjustments as life brings the unexpected, both good and bad.
To build a high degree of confidence in estimating your total retirement need, I suggest making a plan using this process and revisiting it from time to time to make course adjustments.
As you enter the decade leading up to your retirement, you should also consider having a financial plan generated for you by a professional.
If nothing else, it may be worth gaining the peace of mind that a professional can provide, who reviews hundreds of retirement plans each year.
As always, I am grateful for your time and interest. God bless and take care!
