I have come across a few blog posts and magazine articles answering the question ‘how much money do you need for retirement’. Sadly, most people have absolutely no idea how much they will need in order to retire. In order to know how much money you will need in retirement, you need to have an idea of how much you will spend in retirement.
Luckily there are a handful of options for you to figure this out. They range from manual calculations, to plugging some numbers into a program and it telling you just how much money you will need for retirement. Below are the various options for you to figure out your number.
3 Factors For An Accurate Retirement Calculation
In order to get an idea of how much you will spend, you need to assess how much you currently are spending. This requires a budget. I know, I hate them too. For a rough idea of what you spend, look at your previous years bank statements and credit card statements. You can total up all of the expenses for each month of the year and then divide by 12 to get an estimate of your monthly spending.
You may be thinking that your expenses will certainly be less when you retire. After all, you won’t be driving to work every day, you won’t need new clothes for work or have to get your clothes dry cleaned anymore.
While this is true, I don’t think you should cut these out of your estimate. Why? First off, you aren’t going to sit in the house every single day. You are going to go out to lunch to catch up with old friends, start new hobbies, possibly do some work around the house and potentially travel.
You also still need to drive to get to places. That will replace a good portion of your driving to and from work each day. Secondly, all of these things cost money. Money that you currently are not spending, meaning your spending could stay the same or even increase in retirement.
Once you determine a rough estimate of how much you are spending, you are going to have to determine how long you are going to live. I suggest you assume this to be either 90-95. Why so high? Medicine is increasing our life expectancies.
You don’t want to estimate you will live until 80 and save enough to make it to that age and up living until 90. You will run out of money and those last 10 years will be brutal. Imagine having to try to re-enter the workforce when you are 80 years old!
It’s better to have money left over than none at all. For this assumption, take 95 minus the age you plan to retire. Then take the answer and multiply it by your annual spending amount.
Let’s look at an example. Assume you calculated $50,000 in annual spending and you want to retire at 65. The formula is 95 – 65 = 30, and 30 multiplied by $50,000 gives us $1,500,000.
While you have a number, you are not done yet. There is a problem with this number: it does not take into account inflation. Surprisingly, many people are oblivious to the effects of inflation.
Using the historical inflation rate of 3% per year, this means that every year, the cost of goods increases by $0.03 per dollar. So a pack of gum that costs $1.00 today will cost $1.03 next year. A $10,000 car today will cost $10,300 next year. Because of this, the $1,500,000 number we calculated above is too low. Inflation is going to erode your purchasing power.
We need to determine the future value of $1,500,000. In other words, we need to find out what $1,500,000 is worth in 30 years when we take inflation into account. Using the same information above and a 3% inflation rate, we need $3,640,894 saved for retirement.
You read that right. In 30 years, you will need $3.6 million to buy the same amount of goods and services that you can purchase for $1.5 million today.
The formula to get this amount is as follows:
The breakout of the formula is:
P = Present Value
r = interest rate
n = time
So in our example from above, you would place $1,500,000 for P; 3% (or 0.03) for r; and 30 for n.
Now luckily, there are some options out there if you aren’t great with math (or you simply don’t feel like doing the math yourself). All of the options below, and really any good retirement calculator, will take the above factors into account when helping you figure out how much money you need for retirement.
There are two things that Betterment offers to investors with regards to helping with retirement. The first option is for those without an account. If you click here, you can go to the Betterment website, enter in your age and income and they will give you a rough idea of how much money you need per year in retirement. You simply multiply this number out as I showed you above and you have an estimate. (Note that inflation is taken into account here, so you just need to multiply the number by how many years you will be retired.)
The other option they have is RetireGuide. I wrote about this feature here and it is awesome. It analyzes your portfolio and tells you how much money you can withdraw each month without running out of money. I’ve played around with it in my account and love how easy it is to use. To learn more about Betterment, check out my full review.
The 4% Rule
Another option that is fairly popular is the 4% rule. This rule states that you can safely withdraw 4% of your savings in the first year of retirement and then continue withdrawing roughly this amount (depending on inflation) every year going forward. If you do this, chances are you can retire and not run out of money.
Of course, it isn’t 100% foolproof, but has been tested through all sorts of market conditions and has proven to be a valuable tool to help you get a sense of how much money you need for retirement.
For example, if you have $100,000 saved for retirement, then you can withdraw 4% or $4,000 a year and not run out of money. Now, I’m not sure how many of us can live on $4,000 a year (as most of us can’t live on $1,000 a month) so you know you need to build a larger portfolio by saving more money.
Fidelity X Rule
I don’t think it is really called “The X Rule” but it sounds cool to me so I’m sticking with it. The rule talks about how you should have a certain amount saved by certain ages. To see how much you should have saved, you take your salary and multiply it by:
- 1 if you are 35
- 3 if you are 45
- 5 if you are 55
So, if you are 55 and are earning $100,000 then you need to have saved $500,000 ($100,000 x 5). Doing this will help you get to the ending goal of 8 times your ending salary, which according to Fidelity, will allow you to live comfortably in retirement. You can read more about this tool and even change up some variables to your situation to see what it says you need.
Personal Capital is well known for their free investment account aggregator tool (you can learn all about it here – trust me, it’s worth the read) but they tool have an online calculator for retirement planning. You can access it here. It takes all of the variables above into account, as well as a few more, and shows you just how much money you will have at your desired retirement age along with all of the years you will be retired. You can play around with the variables to see just how different saving and spending scenarios effect your retirement. Click here to play around with it.
When you look at the numbers we calculated and see that the average person has less than $100,000 saved for retirement you can clearly see a disconnect. People are not saving anywhere near enough for retirement. Most mainstream articles and news reports suggest saving 10% of your income. Sadly, this is nowhere near enough for many people who have nothing saved.
How much money do you need for retirement? I encourage you to run the numbers to find out. You may be surprised at the number you come up with. But don’t let it depress you. You have 2 options when it comes to having the money needed for retirement:
- Make it a point to save as much as you can each year and then save more each year thereafter.
- Learn to live on less so that your annual expenses are lower.
Don’t fall victim to the thinking that you need to save $3 million dollars. Look over your expenses and see if there are things that you can cut out entirely or just reduce down. If you can find a way to knock off $250 a month from your spending, that comes to $3,000 per year less that you need to save. Over the course of 30 year retirement, that is $90,000! And that isn’t taking inflation into account!
Here are some ideas to cut your monthly expenses and here are some ideas to get your house paid off early. Your house is the biggest expense most people face and by paying off your house, you can drastically lower how much money you need to save for retirement.
If you still are coming up short on your goal, be flexible with your retirement.
Readers, how much money do you need for retirement?
[Photo Credit: Kate Ter Haar]