How Much Money Do I Need to Retire?

It is the most critical question on most people’s minds; yet, because there are so many variables, it is one of the most difficult to answer with any degree of certainty. Considering that saving for retirement is still a relatively new concept, even financial planners are still trying to figure things out. For much of the last century, most people worked until they died. We have also seen the demise of guaranteed pension plans, which has shifted the burden of providing for a secure retirement squarely on the shoulders of individuals. So, the question must be asked, and realizing that many variables come into play, you need to answer it as best you can to have a target to shoot for.

It Starts with Knowing Your Spending Needs

Several formulas can be used to determine how much you will need to live comfortably in retirement, but they are all premised on one key factor – your retirement expenses. Knowing how much money you will need to save for retirement is more straightforward when you know how much you will be spending in retirement. If your time horizon is still a ways off, estimating your expenses might be more difficult, but if you are within ten years, it can be a more realistic exercise. In either case, having a clear vision of what you want your retirement to look like will make it easier to estimate what it will cost.

The exercise involves creating a monthly budget around your expected retirement lifestyle. Of course, it needs to account for any changes you expect to make in your finances and lifestyle between now and then. For example, will you downsize your home or move to a less expensive area? Will you be carrying any debt into retirement? Will you have any dependents relying on your financial support? How will your spending change between now and retirement? The idea is to create your retirement budget now based on your vision for retirement and adjust it as your circumstances or goals change.

Many financial planners suggest using the 70 percent rule to form a baseline for your budget. The rule says that, on average, retirees can expect to replace 70 to 80 percent of their income in retirement. It assumes that some expenses will decrease, such as work-related costs (commuting, professional fees, dining out for lunch, clothing, etc.) and housing costs. But don’t assume you will spend less money across the board.

Other expenses may increase, such as travel and leisure. To plan more conservatively, you can start with a higher baseline of 80 to 90 percent. Your budget number, the amount you expect to spend each month, becomes your target because you will need to accumulate enough capital to hit it every month for the next 25 or 30 years or more.

Next, you can subtract the income you expect from Social Security and other income sources, such as a pension. You can use the retirement estimator at www.ssa.gov for a current projection of your Social Security benefit. If you are to receive a pension benefit, your pension administrator can provide you with an estimate of your income at retirement.

Don’t Forget Your Medical Expenses

You also have to plan for medical costs and other unexpected expenses. According to Fidelity Benefits Consulting, a 65-year-old couple will spend $315,000 on medical expenses throughout their retirement, which doesn’t include long-term care costs. In addition, you will need a spending cushion or cash reserve to cover unexpected expenses. The recommended amount to set aside in cash reserves is 12 months’ living expenses. These additional requirements should be funded separately and added to the capital needed for your retirement income.

Work Backwards to Find Your Number

One of the more commonly used rules to calculate how big of a nest egg you need to build is the 4 percent rule. This is the rate at which you can draw down your assets each year without the risk of outliving your assets. The 4 percent drawdown, which should be adjusted annually for inflation, is based on a portfolio with an asset allocation of 50 percent stocks and 50 percent bonds.

For example, if you and your spouse receive $4,000 per month ($48,000 a year) in Social Security benefits and need $80,000 to cover your living expenses, you must generate $32,000 from your savings. Using the 4 percent rule, you must accumulate $800,000 of capital ($32,000/.04 = $800,000).

It’s a Continuous Planning Process

The key to making the 4 percent rule work is to make minor, incremental adjustments to the drawdown rate as circumstances dictate. You can do this by recalculating your drawdown rate based on your portfolio value. For example, if, as a result of your withdrawals and poor investment performance, your savings balance has declined, you could adjust by forgoing an inflation increase or scaling back your drawdown for a year or two. Conversely, you could increase your spending or cushion during years of robust returns. You could also plan conservatively using a lower drawdown rate, such as 3.5 percent. It would require more capital at retirement but also account for greater uncertainty.

Following established rules and guidelines can be helpful for baseline planning. However, it is essential to consider your unique circumstances, needs, and attitude toward money when developing a retirement income strategy. To achieve lifetime income sufficiency, you should always seek the guidance of an unbiased and qualified financial advisor.