Retirement planning conversations often begin with a simple question: how much money does it take to retire? This simple question bubbles to the top for nearly every pre-retiree.
It’s a simple question, but not such a simple answer.
The answer is a complicated mixture that should account for a number of variables. Some of these variables include the following:
- How much money will I spend each year in retirement?
- What income sources (and how much) will I have?
- How old am I and how long will I live?
- How much will I pay in income taxes?
- What will inflation be?
- How will the markets perform?
These questions loosely brush the surface of the many factors that can impact a retirement plan.
Still, it’s prudent to answer the question of How much money does it take to retire? So, where to begin?
There are several calculations we can look at to start. Some calculations are simple rules of thumb and others involve a more detailed analysis. All, in my opinion, are independently incomplete.
However, paired with other information, these calculations can be used as the foundation for a full retirement plan.
Retirement Number 1 – “X” times salary
“X” times your salary is one of the easier calculations that can be used to answer how much money you need to retire. Unfortunately, depending on whom you read and where you get your information, “X” (the key multiple) can be wildly different.
Generally, I’ve seen this number as low as 8 times and as high as 12 times for a 60-something retiree. How good is this estimate? Let’s take a look.
Let’s assume the hypothetical example of a 62-year-old retiree who makes $100,000 per year. We will compare the 8x salary to 12x salary strategies.
8 times salary: 8 x $100,000 = $800,000
12 times salary: 12 x $100,000 = $1,200,000.
We quickly notice a difference of 50% in projected retirement savings needed from one scenario to the next. I don’t know about you, but I can’t imagine that too many retirees would feel comfortable making a decision based on this information.
In fact, this difference is so large that it may be the difference between running out of money or not in retirement. Or it may be the difference between working or retiring, or the difference between needing to save or not.
Furthermore, it’s important to understand what factors these rules of thumb are based on. Often, they make assumptions for how many years you will spend in retirement, inflation, income replacement rate, and market performance. In an effort to serve the masses, X times salary often oversimplifies what is anything but easy.
Target a Withdrawal Percentage
Another common rule of thumb in retirement suggests being able to withdrawal 3-5% of your total account balance without running out of money. Historically, several studies have suggested that had you withdrawn 4% of your initial retirement portfolio, adjusted it annually for inflation, and invested in a 50/50 portfolio, you would have had an 85% chance of not running out of money.
Using a withdrawal percentage as a starting point, we can calculate back into an amount that a retiree would need to save in order to retire.
Assuming you need $50,000 per year from your investments to meet your retirement goals and a 4% withdrawal rate, a retiree would need to accumulate $1,250,000 in investable assets. ($50,000 divided by 4%)
If the need is $100,000 per year, the amount needed to retire would be $2,500,000.
As of late, more questions are being asked regarding the rule of thumb suggesting that a 3-5% withdrawal rate is sustainable. While historically this may have produced positive results, the world is a different place.
Current interest rates have declined, projected market performance has tempered, and projected longevity has increased. The combination of these forces has caused many experts to re-examine the sustainability of the said withdrawal rates.
Retirement Without Spending Down Principal
One old-school thought when addressing how much a person needs to retire is to establish a retirement plan that never spends the principal. The goal would be to use dividends, interest, and capital gains to generate income in retirement.
This strategy assumes that one can take a specified amount from the investment portfolio every year and not spend down the principal.
In theory, this strategy is great. Who wouldn’t want this? However, in practice, it leaves a lot to be desired.
- Where do you get yield in a low interest rate environment?
- What happens when that yield changes?
- How do withdrawals keep pace with inflation?
In order to calculate the need, it is necessary to figure a specified yield.
Assuming a 3% yield (which is not intended to be reflective of any risk tolerance or current market. It is a hypothetical example used to illustrate a point) and a $50,000 per year withdrawal, the amount saved prior to retirement would need to be $1,666,667.
Retirement Need as a Mathematical Calculation
The above example may be used to provide a broad answer regarding what may need to be saved in order to reach your retirement goals.
Other methods of determining your need focus on the numbers and include detailed calculations. One such method starts with a detailed budget that concentrates on your retirement expense needs.
From your expense needs, a tax analysis would add projected income taxes that are owed. This leads to your total expense need.
From a total expense, deductions are taken for specific retirement income sources, such as pensions and Social Security. What you’re left with is a net need that you will need to withdraw from your investments.
From this net need, it’s easy to calculate an amount that needs to be saved prior to retirement. A chart of the need, based on various rates of return, can be found below:
|Rate of Return||3.00%||4.00%||5.00%|
|Inflation Adjusted ROR||0.00%||0.97%||1.94%|
|Years to Retirement||15||15||15|
|Years in Retirement||33||33||33|
|Need from Investments||$50,000||$50,000||$50,000|
|Need (Inflation Adjusted)||$77,898||$77,898||$77,898|
|Inflation Adjusted Need at Retirement||$2,570,646||$2,211,775||$1,921,615|
In this example, the amount needed prior to retirement ranges from $1,900,000 to $2,500,000, depending on the assumed rate of return.
(The above amounts are higher than the above examples, mainly because we have increased the expected withdrawal need at retirement due to inflation. Said another way, the need is currently $50,000. Assuming a 3% inflation rate, the need is $77,898 in 15 years when retirement begins.)
It’s interesting to note that withdrawal rates for a 33-year retirement range from 3% to 4%, in line with our example above.
- $77,898 / $2,570,646 = 3.0%
- $77,898 / $1,921,615 = 4.1%
A secondary question that often arises from this analysis is how much a person needs to save to reach their goals. Continuing this example, we can calculate just how much annual savings is needed to reach a given goal.
|Projected Assets at 62||$778,984||$900,472||$1,039,464|
|Shortfall on Goal||($1,791,663)||($1,311,303)||($882,151)|
|Level Payments t0 Save||$96,332||$65,488||$40,881|
Assuming the current amount saved is $500,000 and that there are 13 years until retirement, this pre-retiree would need to save anywhere from $40,000 per year to $96,000 per year to reach the set goal.
(This example illustrates the power of an additional 1% or 2% rate of return on investments over many years)
Additional Retirement Analysis
In any retirement plan, whether following a rule of thumb or a detailed calculation, it’s important to remember that there are no certainties, no guarantees and no perfect plan. Retirement plans involve projections into the future, which is inherently uncertain. What every retirement plan should have is flexibility. More specifically, it requires flexibility to adjust and accommodate the ever-changing marketplace.
While the examples above all provide an answer to the question of how much money it takes to retire, all of them include additional issues that need to be addressed. For example, income tax, longevity, market returns, inflation, and other topics will all impact just how much needs to be saved.
Retirement planning is assumption-based planning that attempts to evaluate and interpret future occurrences. This type of assumption-based planning is necessary to add confidence when answering the all-important question of How much money do I need to retire?
These projections are hypothetical. This information is meant to provide you with a general idea about your retirement income needs. The results given are for illustrative purposes only and do not represent the actual performance of any current or future investment. Rates of return will vary over time, especially for long-term investments.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market.