Saving for retirement is funny. We are told to start as soon as possible. So year after year after year… we save. But when is it enough? How much do we actually need? That’s why you need a “retirement number.” Until you have a retirement number, you have no idea whether or not you’re on track.
In this article we’ll cover the steps to determining your retirement number, keeping a running example so you can see how the process works.
Step One: Determine How Much You’ll Need
This step is to determine lifestyle requirements. Experts say people need 80% of what they earn today for their retirement years. This rule of thumb is not perfect, but it’s a good starting point.
So if you make $80,000 annually, this logic says you’ll need $64,000 per year during your retirement. Using $64,000 annually, that’s about $5,300 a month in gross income in retirement.
Contrast your current expenses with your retirement-age anticipated expenses in retirement.
|Expense||How will it change in retirement?||Current cost||Retirement cost|
|Mortgage||It will be paid off by the time you retire!||$1,400||$0|
|Healthcare||You’ll have Medicare, but overall costs will rise||$200||$900|
|Taxes||You’ll still have to pay taxes but in a much lower bracket||$1,600||$795|
|Cost of living||Maybe you’ll move to a location less expensive (food, entertainment)||$600||$400|
|Student loans||These will be paid off!||$400||$0|
|Family||Costs of raising children should be complete (clothes, school supplies)||$300||$0|
|Travel||With all this time on your hands, you’ll need to account for travel||$0||$2,000|
So in this case, your monthly expenses will be $4,095.
Keep in mind that these are just assumptions and are likely to change.
For example, it’s true your tax rate will likely be lower in retirement than it is today, but remember this: 1. America has a lot of debt; 2. We are going through tax reform. In other words, overestimate your tax rate to be safe.
Step Two: Apply the “Safe Withdrawal Rate”
Now it’s time for math. There is something in retirement planning known as the safe withdrawal rate. It is the amount you can withdraw from your retirement savings without ever depleting your portfolio. Under the safe withdrawal rate, you should be able to withdraw 4% of your portfolio each year, without your retirement funds ever running dry.
The theory is based on the fact that the historic rate of return in the stock market (since 1926) is somewhere between 8% and 10% per year. So if you limit your withdrawals to only 4% when your portfolio is growing between 8% and 10%, you’ll have an extra 4% to 6% to cover inflation and allow the portfolio to keep growing.
But how much will you need in your portfolio to be able to withdrawal only 4% to cover your monthly expenses in retirement?
If your retirement expenses are $4,095 * 12 months = $49,140 (annual income) divided by 0.04 = $1,228,500. So yes, to collect just over $4,000 per month, you need well over a million dollars in retirement accounts. Just to be safe, we’ll round that up to $1.5 million for the rest of the steps.
Step Three: Don’t Forget Inflation
One of the biggest variables in retirement planning is inflation. Not factoring in inflation can result in retirees coming up short. How do we calculate future inflation?
Let’s say you’re 40 years old and you want to retire in 25 years when you turn 65. Using the Bureau of Labor Statistics’ Inflation Calculator, we can go back 25 years — to 1992 — to see what inflation has done to the value of the dollar in that time.
By entering $1 as the value, and 1992 as the year, we find that it takes $1.73 today to buy what $1 purchased in 1992.
Rounding $1.73 up to $2, we can reasonably assume that inflation will roughly double the amount of money that you need to have in your retirement portfolio by the time you retire. So $1.5 million, based on the value of a dollar in 2017, will need to grow to $3 million in 25 years in order to provide the same purchasing power.
Thus $3 million becomes the goal for how much money you will really need to retire comfortably.
Step Four: Use a Retirement Calculator
Now that you know how much money you will need to retire — $3 million — the next step is to figure out how to reach the goal.
I’ve already calculated the numbers that will get you to the goal of $3 million, based on the following assumptions:
- Percent to contribute: 18%
- Annual salary: $80,000
- Annual salary increase: 2%
- Current age: 40
- Age of retirement: 65
- Current 401(k) balance: $130,000
- Annual rate of return: 9%
- Employer match: 50%
- Employer match ends: 7%
Based on these assumptions, you can reach a portfolio size of $2.9 by the time you reach age 65 by contributing 18% of your annual income to your employer’s 401(k) plan.
Once you establish a goal for your retirement portfolio size, getting there is mostly a math problem. Work up your number using circumstances and assumptions that are unique to your own situation.
Just make sure that you do establish a retirement goal. That way you know exactly where you’re heading and what you have to do to get there.
And be sure that you give yourself wiggle room, since much of retirement planning is based on assumptions.