Have you ever tried to figure out what you needed to save for retirement? Does it feel completely daunting?
With inflation, assumed rates of return, and guidelines for how much you should withdraw, how do you figure out how much you’ll need for retirement, and what do you need to do today to ensure you don’t spend the last third of your life in poverty?
Take a deep breath. You don’t need to be a math whiz or a stockbroker to figure this out. It’s a straightforward process that takes just a few minutes.
First you want to figure out how much in today’s dollars you would like to have for your annual retirement income. Keep in mind your kids will be grown up and on their own, and you won’t (or at least shouldn’t) have a mortgage. Those are two huge expenses that won’t factor into what you need in retirement.
That said, you may want to do some traveling, save more for medical expenses, spoil grandchildren, and increase your giving.
Don’t get analysis paralysis with this exercise. A ballpark figure is fine and you can always adjust course. For example’s sake, let’s say you would like an annual income of $75,000 in today’s dollars. Without a mortgage or kids to take care of, you would be more than okay.
We’ll use the rule of 4% to see how much in today’s dollars you would need for your nest egg. This is an investing guideline that says if you withdraw 4% of your retirement savings every year, adjusting withdrawals each year for inflation, you have less than a 10% chance of outliving your money after 30 years.
$75,000 / .04 = $1,875,000
$75,000 is 4% of $1,875,000. In other words, you need $1,875,000 in today’s dollars to retire on $75,000 a year.
However, you’re not retiring with today’s dollars. Because of inflation, a $75,000 income in 30 years will not afford the lifestyle that $75,000 today does.
So we need to factor in inflation. How do we do that? Thankfully, this math is simple. At an average annual inflation rate of 3%*, $75,000 becomes $77,250 (75,000 x 1.03) after one year. After two years, $75,000 becomes $79,567 (77,250 x 1.03).
After 30 years, $75,000 becomes $182,044.69.
Now that we have inflation figured out, let’s use the rule of 4% again with an annual income of $182,044.69.
$182,044.69 / .04 = $4,551,117
Using the rule of 4%, we can determine that $4,551,117 will be required to annually withdraw today’s equivalent of $75,000 in 30 years.
What’s wonderful about this formula is you can swap out the numbers to run different scenarios. You can replace a 30 year timeline with 10 or 40. You can change $75,000 to $40,000 or to $150,000.
Continuing with our example, we have now established a goal to save about $4.5 million in 30 years. Now that we know what you need to save for retirement, how do you figure out if you’re on track?
There are good retirement savings calculators out there, but they all require you to enter the variables. This is where it can get tricky unless you know what numbers to plug in. I personally like to use an implied rate of return of 8%** and most investment professionals will recommend the same. This figure assumes I’m going to average an 8% annual return on my investments over the next 30 years. In other words, for every dollar I invest, I’ll earn 8 cents***.
From there, enter the rest of the numbers. How much do you already have in retirement accounts, and how much are you contributing monthly? Then you can see how close you are to meeting your target. If you’re projected to be way under your goal, tweak the monthly contribution to figure out how much you need to be saving.
One thing to remember: don’t get discouraged if you’re not yet on track. Look at your budget, see where you could save a little more, and aim to contribute 15% of your gross income in retirement accounts. Your household income is likely to go up over the years, and consistency is a big part of the equation. If debt is tying up your ability to save, take it one step at a time by paying off your debt and building an emergency fund first. Then you’ll have plenty of room in the budget to save for retirement.
*The Bureau of Labor Statistics reported an average inflation rate of 3.18% between 1913 and 2015.
**Dave Ramsey likes to use a 12% implied rate of return, and that’s fine; I’m just more comfortable making my savings goals according to a more conservative rate of return, especially because as I near retirement, I’ll start putting more money into conservative investments that don’t earn 12%. But more on that another time.
***The following year, I’ll earn another 8% on all dollars invested and 8% on the interest I’ve earned. This is the magic of compound interest.
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