Figuring out how much money you need to retire is like one of those word problems from high school that still haunts you. “If X equals your spending in retirement, Y equals your rate of return and Z equals the number of years you will live, how much will you need to save, given that X, Y and Z are all unknowable?”
The retirement equation isn’t unsolvable, but it’s not a precise calculation, either. You’ll need to revisit your retirement formula once or twice a year to make sure it’s on track, and be prepared to make adjustments if it isn’t. Weigh these four factors to get a better handle on how much money you will need to retire.
Factor No. 1: How much will you spend?
The rule of thumb is that you’ll need about 80 percent of your pre-retirement income when you leave your job, although that rule requires a pretty flexible thumb. The 80 percent rule comes from the fact that you will no longer be paying payroll taxes toward Social Security (although you may have to pay some taxes on your Social Security benefits), and you won’t be shoveling money into your 401(k) or other savings plan. In addition, you’ll save on the usual costs of going to work — the pandemic won’t keep everyone at home forever — such as new clothing, dry cleaning bills, commuting expenses and the like.
You also need to factor in any pension or Social Security income you’ll be getting. If your annual pre-retirement expenses are $50,000, for example, you’d want retirement income of $40,000 if you followed the 80 percent rule of thumb. If you and your spouse will collect $2,000 a month from Social Security, or $24,000 a year, you’d need about $16,000 a year from your savings. Bear in mind, however, that any withdrawals from a tax-deferred savings account, such as a traditional IRA or a 401(k) plan, would be reduced by the amount of taxes you pay.
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This calculation doesn’t consider other things you might want to spend money on. “In the first three years of retirement, the biggest expense is often travel,” says Mark Bass, a financial planner in Lubbock, Texas. “They want to take a four-week trip somewhere, maybe pay business class to get there, and it can cost $20,000 or so.” That’s not a problem, Bass says, as long as you build it into your budget and the trip doesn’t end in the poorhouse.
Medical care is another expense that people in retirement often don’t factor in. The standard monthly premium for Medicare Part B, which covers most doctors’ services, is $148.50 or higher, depending on your income. You also have to pay 20 percent of the Medicare-approved amount for doctor’s bills as well as a $203 deductible. All told, the average couple will need $295,000 after taxes to cover medical expenses in retirement, excluding long-term care, according to estimates from Fidelity Investments.
Finally, there’s the question of how much, if anything, you wish to leave to your children or charity. Some people want to leave their entire savings to their children or the church of their choice — which is fine, but it requires a much higher savings rate than a plan that simply wants your money to last as long as you do.
Factor No. 2: How much will you earn on your savings?
No one knows what stocks, bonds or bank certificates of deposit will earn in the next 20 years or so. We can look at long-term historical returns to get some ideas. According to Morningstar, stocks have earned an average 10.29 percent a year since 1926 — a period that includes the Great Depression as well as the Great Recession. Bonds have earned an average 5.33 percent a year over the same time. Treasury bills, a proxy for what you might get from a bank deposit, have returned about 3 percent a year.
Most people don’t keep 100 percent of their retirement savings in a single investment, however. While they might have part of their portfolio in stocks for growth of capital, they often have part in bonds to cushion the inevitable declines in stocks. According to the Vanguard Group, a mix of 60 percent stocks and 40 percent bonds has returned an average 8.84 percent a year since 1926; a mix of 60 percent bonds and 40 percent stocks has gained an average 7.82 percent.
Financial planners often recommend caution when estimating portfolio returns. Gary Schatsky, a New York financial planner, aims at 2.5 percent returns after inflation, which would be about 3.5 percent today. “It’s an extraordinarily low number,” he says, although it’s probably better to aim too low and be wrong than aim too high and be wrong.
Factor No. 3: How long will you live?
Since no one really knows the answer to that question, it’s best to look at averages. At 65, the average man can expect to live another 18 years, to 83, according to Social Security. The average 65-year-old woman can expect another 20.5 years, to 85 1/2.
“Most people err on the shorter side of the estimate,” says Schatsky. That can be a big misjudgment: If you plan your retirement based on living to 80, your 81st birthday might not be as festive as you’d like.
It makes sense to think about how long your parents and grandparents lived when you try to estimate how long you’ll need your money. “If you’re married and both sets of parents lived into their late 90s, the only way you’re not getting there is if don’t look both ways when you cross the street,” Bass, the Texas financial planner, says. Unless you know you’re in frail health, however, it’s probably best to plan to live 25 years after retirement — to age 90.
Factor No. 4: How much can you withdraw from savings each year?
A landmark 1998 study from Trinity College in Texas tried to find the most sustainable withdrawal rate from retirement savings accounts over various time periods. The study found that an investor with a portfolio of 50 percent stocks and 50 percent bonds could withdraw 4 percent of the portfolio in the first year and adjust the withdrawal amount by the rate of inflation each subsequent year with little danger of running out of money before dying.
For example, if you have $250,000 in savings, you could withdraw $10,000 in the first year and adjust that amount upward for inflation each year for the next 30 years. Higher withdrawal rates starting above 7 percent annually greatly increased the odds that the portfolio would run out of money within 30 years.
More recent analyses of the 4 percent rule have suggested that you can improve on the Trinity results with a few simple adjustments — not withdrawing money from your stock fund in a bear-market year, for example, or foregoing inflation “raises” for several years at a time. At least at first, however, it’s best to be conservative in withdrawals from your savings, if you can.
The 4 percent rule is very conservative for most people: A $1 million retirement nest egg would generate $40,000 a year in income. For many people, working a bit longer will help close up the savings gap. Not only will you continue to bring in a paycheck, but you’ll get the advantage of delaying Social Security benefits, which rise each year you wait by 8 percent between your full retirement age and age 70. And it lets you save more. “It’s a serious decision when you decide to retire, because you can’t turn the spigot back on,” says Schatsky. “Every day you work gives you the ability to increase your retirement enjoyment later.”