Figuring out how much you need to retire is like one of those math problems from high school – if X equals your spending in retirement, Y equals your rate of return and Z assumes your life expectancy, how much would you need if all are 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’ll need to retire.
How much will you spend?
The rule of thumb is that you’ll need 80 percent of your pre-retirement income when you leave your job, although that rule requires flexibility. 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 putting money into your 401(k) or other savings plan. In addition, you’ll save on the usual costs of going to work, such as new clothing, dry cleaning bills, commuting expenses, etc.
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. Important to note, this calculation doesn’t consider things you may to spend money on (travel, hobbies). In addition, Medicare is another expense that people don’t often factor in.
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 10.29 percent a year since 1926, a period that include the Great Depression as well as the Great Recession. Bonds have earned 5.33 percent a year over the same period.1
We recommend that you use caution when calculating these earnings. It’s probably better to aim low and be wrong than aim too high and be wrong.
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 851/2. Most people err on the shorter side of the estimate. That can be a big misjudgment.2
How much can you withdraw from savings each year?
The traditional rule of thumb followed the 4 percent rule of the portfolio in the first year and adjust the withdrawal amount by the rate of inflation each subsequent year. The 4 percent rule is very conservative for most people. 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 benefits, which rise each year you wait by 8 percent between your full retirement age and age 70.