Many of us look forward to the day we will be able to retire from work. And some are able to accomplish this feat sooner than others. But how much do you need to retire? Granted, it is not possible to determine exactly how much you need to retire.
However, some broad guidelines have been established over the years. Of course you will always have to tailor such “rules of thumb” to your own personal situation. But they can be used as a guide to compute some ballpark estimates.
Most experts predict that on average, net living expenses decrease about 20% after retirement. As such, they recommend replacement of about 80% of pre-retirement income which was used for such expenses. This should allow you to maintain your current lifestyle.
For those with average income, Social Security Retirement Benefits generally replace about 40% of those earnings. This percentage is higher for lower income individuals, and lower for those who earn above average incomes.
So the average individual then needs to accumulate enough principal by retirement to close the gap. This is typically done by saving and investing.
Before proceeding further with some calculations, it is important to consider how your living expenses may change after you retire.
Examples of How Your Living Expenses During Retirement May Be Lower
Although everyone’s individual circumstances are different, we often see some common similarities. Following is a brief discussion of some ways your expenses may be lower, which will reduce the amount you will need to retire.
Lower Transportation Costs Since You’re Not Working
A significant portion of your transportation costs during your working years consists of your daily commute to and from work. So when you stop working, these costs should decrease on average. If Some multi-car households may even decide to move forward with only one vehicle. Regardless, you should be able to save on gas, car insurance, train tickets, etc. These savings can be significant.
Mortgage is Paid-Off
Most mortgage loans have 15 or 30 year terms. Many borrowers have refinanced in the past few years due to the historically low mortgage interest rates. But nonetheless, you will hopefully have paid off your mortgage by the time you retire.
Children Are Grown And No Longer Dependent On You (Hopefully)
Many college graduates often move back home after college. But after a few years of working and saving up some money, they usually go out to fulfill their desire for independence. This can result in savings for you in several areas. Some examples are books, tuition, room and board, food, auto insurance, health insurance, clothing, utilities, etc.
Moving To A Smaller Home and/or Less Expensive Area
Many retirees move after they reach retirement. They may do so due to their preference for a particular locale. It may be a warmer climate or other reasons. But often the move also has to do with financial considerations.
The new home may have lower overall expenses. It will usually be smaller, and may be in a lower tax area. Either way, property taxes, utilities, insurance, and maintenance may be lower. Not to mention that you will likely have cash left over from the sales proceeds of the larger home.
Some Post-Retirement Expenses May Increase
Although your net expenses should decrease, there are several areas in which you may find yourself spending more. These items can also affect the amount you will need to retire. Some more than others.
Higher Expenses Due To Inflation
Inflation causes the price of many products and services to rise over time. And inflation does not go away once you retire. You will notice the usual increases in the cost of groceries, utilities, property taxes, and other items. But on the flip side, at least you can hedge against this inflation with assets you may own such as your home and investments.
Assuming you do not have coverage through a former employer, your health care costs may increase. Granted you will have Medicare coverage. But adding supplemental policies to fill in any gaps can result in an overall increase in costs. Not to mention that as we get older, we generally face more health issues. As a result, copays, deductibles, and coinsurance amounts for medicines and medical visits and procedures can add up.
Potentially Higher Utility Costs
Fewer individuals in the home can lower the water, electricity, and potentially even the cable bills. But being in the home longer as a retiree can at least partly offset these savings. On the bright side, being in the home more frequently as a retiree may allow you to save some money on your home insurance premium.
Travel and Expensive Hobbies
It is not uncommon for retirees to plan on spending their golden years ticking off items on their “bucket list” which they’ve postponed for many years. This can include traveling, regular vacations, expensive hobbies, etc. Such plans and goals can be the “wild-card” in determining how much you need to accumulate in savings.
But because these are “wants” and not “needs”, they are not required to enjoy a comfortable retirement by maintaining your current standard of living.
It is Critical To Start Early In Accumulating The Funds You Will Need To Retire
Starting to save as soon as possible is very important. The power of compounding works best with time. For example, let’s say you save 5,000 per year from the time you are 25 until you retire at 65. Assuming an 8% annual rate of return on your investments, you will have accumulated $1,295,283 by the time you retire.
Now what if you didn’t get your act together until later in life? For whatever reason, let’s say you didn’t start saving and investing until you were 45. In order to make up for lost time, you find a way to save 10,000 per year towards your retirement goals. Assuming the same 8% annual rate of return, you will have accumulated $457,620 by the time you are 65.
So in each example above, you would have saved and invested $200,000 over the years from your wages. But starting to invest at 25 rather than 45 allowed more of that money to grow for a longer period of time. In this case, the difference would be a staggering $837,663.
Estimate The Amount Of Income Your Savings Must Generate During Retirement
In determining how much you will need to retire, you must first calculate an estimate of the annual income your retirement savings must provide. So let’s say your current annual income is $45,000. You save 15% or $6,750 towards retirement and other goals. And you utilize the remaining $38,250 for your living expenses.
Let’s also say you are 40. Assuming an average 3% annual rate of inflation, your pre-retirement living expenses will be $80,087 by the time you reach 65 years of age. If your income also grows in-line with inflation, it will top out at $94,220.
Eighty percent of your pre-retirement living expenses would amount to $64,070 in this example. This is approximately the income you would need to maintain your standard of living. Let’s also go with the assumption that Social Security benefits will amount to roughly 40% of pre-retirement income, or $37,688 in this case. That leaves a $26,382 annual income gap in this example.
How Big of a Nest Egg Do You Need To Retire?
Now that we have the income gap we need to close, we must compute the estimated accumulated savings that will accomplish this goal. There are several ways to calculate this amount.
One well known rule of thumb is the 4% rule. It originated in the 1990s from a study done by a financial advisor named William Bengen. A similar study was also done a few years later by a group of college professors at Trinity University in Texas.
This rule generally states that based on (U.S.)historical data, it is safe to spend 4% from your retirement savings each year without running out of money over a thirty year retirement period. The initial 4% amount is adjusted (up or down) for inflation each subsequent year. Further, a U.S. stock allocation of between 50-75% is assumed. The rest would be invested in intermediate term high quality bonds such as treasuries.
So, according to this rule, if you need your savings to generate $26,382 of income each year, you must accumulate about $659,550 ($26,382/.04) by the time you retire.
Remember This Is A Rule of Thumb Based On Specific Assumptions
It is key to remember that the 4% rule is based on historical returns of specific types of securities. Actual future results of the same or other investments can and likely will differ. They may be better or worse. The rule generally holds up given the worst market declines and bouts of inflation we’ve seen thus far over a very long historical period of time. But no one knows what may happen in the future.
It also assumes a specific time horizon. Your personal situation and risk tolerance are key determinants in how you may modify your own investment goals. Someone may have a shorter time horizon due to late retirement or a terminal illness, for example. With a shorter time horizon you may be able to have a higher spending rate and/or a lower stock allocation and still maintain the same degree of safety that you will not exhaust your funds.
Alternatively, you may accept a higher withdrawal rate and/or lower stock allocation even with a long time horizon because you may be willing to accept a somewhat higher risk of running out of money. For example, someone may be okay with an 80% chance that their nest egg will not be exhausted versus something closer to 100%. Everyone has different preferences.
With that said, the 4% rule can be a useful tool in giving you a sense of how much you may need to retire.
Moving To All Cash At Retirement Is Likely Too Risky
As mentioned above, the 4% rule does allow for an increase in each subsequent annual withdrawal amount based on inflation. So, for example, assuming a 3% inflation rate, the second year’s retirement savings spending amount would be $27,173 ($26,382 x 1.03).
If you were to liquidate all your investments upon reaching retirement and spend 4% plus inflation each year, you may run out of money prematurely. Not to mention the potential immediate tax consequences of liquidation for investments not inside qualified retirement accounts.
Cash and cash equivalents will barely keep up with inflation at best. Even then, your money would run out after 25 years (assuming you saved 25 times living expenses). More likely, the portfolio longevity would be significantly shorter.
Not to mention that you will probably have little if anything of your savings to pass on to your heirs. Plus you will have foregone the opportunity to potentially increase your spending power later in retirement by investing in higher earning, albeit more volatile, investments.
Now moving to cash, certificates of deposit (CDs), and treasury bills is certainly an option. But it would not be an acceptable one for many retirees, especially since many individuals are living longer. Time horizon plays a big part in this decision.
A Mix of Stocks and Fixed Income Securities Is More Likely To Outpace Inflation
But the 4% rule does not assume you will liquidate everything and move to all cash upon retirement. It does instead assume you will have a relatively balanced portfolio of stocks and bonds in order to generate the income necessary to pay your inflation adjusted living expenses over a relatively long time horizon.
So as long as you earn at least the inflation rate, or an average of about 3% historically, then you should not have to dip into the original principal. You will be able to pay your living expenses from your investment returns (interest, dividends, and capital gains earned). Not to mention that you will most likely have a substantial inheritance to leave to your heirs.
Investments Do Not Earn Their Historical Average Every Year
It’s important to understand that investments are volatile. They do not earn their historical averages evenly each year. Stock, as well as bond markets can and do fluctuate. Inflation also fluctuates. So the real return of even “safe” cash equivalent investments such as CDs can vary significantly. It may even be negative.
Granted you may reduce your equities exposure before or during retirement, but not completely. You will still likely have exposure to stocks as well as bonds in order to increase your chances of outpacing inflation.
The studies referenced above looked at retirement periods throughout several decades. These studies revealed that with stock allocations of 50 to 75%, the retiree can have high confidence that they will not exhaust their portfolio within 30 years given a 4% spending rate.
Spending Rates Can Also Change or Fluctuate
Besides investment returns fluctuating and deviating from historical averages, spending requirements can also vary. An emergency or life change, for example, may require more or less than the 4% withdrawal rate. Increasing the withdrawal rate will raise the risk that you may exhaust the portfolio given the same time horizon.
Retirees should resist the temptation to increase their spending rate early on in response to above average returns. These returns can be a cushion for a potential reversion to the mean or large market decline later on in retirement.
A Significant Stock Allocation May Even Allow You To Increase Your Original Retirement Savings
Given a 50-75% stock allocation, the studies also revealed that in many cases, not only was the initial principal not exhausted, it was increased. Sometimes very substantially. The reason being that the investment mix often earned more than the inflation rate over many years.
So 4% is a relatively safe and conservative rule of thumb in helping you determine an estimate of how much you need to retire. It will also allow you to leave a significant legacy in most cases. This is an important secondary goal for many individuals.
It is smart to do some ballpark calculations to determine approximately how much you may need to retire. You don’t want to be surprised when it’s too late.
This can also motivate you to make any necessary changes. Such actions may help improve your chances of meeting your retirement goals.