How Much Do You Really Need to Retire
There are many variables that go into deciding how much you need to save for your retirement.
Financial service firms will tell you that you need to save anywhere from 8 – 11 times your current income, up to 10 – 15 times your current income, to be able to maintain your current living standards in retirement. While it would be nice to be able to do that, only a small percentage of the population will earn enough in their lifetimes after taxes and living expenses to retire with that much money.
Keep this in mind when hearing those numbers though. The more assets under management, the more the investment banks make. What do you think their research is going to show you? Do you think they’re going to promote a low number or high number when telling you how much to save? They’re going to be on the conservative side, because it makes them more money.
The general rule of thumb pushed by most financial advisors and investment banks is that when you retire, you should have enough money saved to replace 80% of your pre-retirement income. That means you‘d be able to withdraw enough money each year from your retirement account to “pay yourself” 80% of your pre-retirement annual income.
Is that really necessary?
First of all when you retire, you’re typically making less money, so the amount you pay in taxes goes down. That puts more money in your pocket.
Next, you won’t be spending as much on work-related activities, so your costs for gas and other work expenses decrease. Your children will be out of the house, which frees up an incredible amount of money that you would have otherwise spent on food, insurance, activities and saving for college.
Then take into consideration that you’re no longer saving 10-15% of your income for your retirement or setting aside additional money for an unexpected job loss. Those are significant expenses that no longer apply once you retire with enough money.
Don’t forget about strategies to live on less money during retirement, but still live a full and exciting life. The biggest money savers include not retiring until you reach age 70, continuing to work part-time into your retirement at a job you enjoy, selling your house to raise cash and moving to a state, city or even a country outside of the United States with a lower cost of living, as more and more retirees are doing.
If you take all the above into consideration, ask yourself if you’ll really need 80% of your current income every year during retirement, or if that number is in fact, actually less? You may find that you need less than you think. Only you can determine the answer based on what you want to do during retirement and the lifestyle you want to lead.
I would be remiss if I didn’t mention your biggest expense during retirement, medical costs. Right now the U.S. spends 17.7% of its GDP on health care costs. The next highest developed country drops all the way down to 11.9%. Our health care costs continue to rise faster than any other developed country. The United States spends over 50% more per capita on health care than the next highest nation, and nearly double the average of the top 15 developed nations.
Even with all that spending, rating systems such as the one put out by the World Health Organization and Bloomberg, the United States hasn’t even been able to crack the top 30 in terms of quality of health care for everyone. If our government can ever get its act together so that we can maintain social security and reduce our rising health care costs, it will be of great help to all retirees.
Now let’s talk about the amount of money you can safely withdraw each year from your retirement account to get a final total estimate of approximately how much money you’ll need to retire comfortably.
The general rule of thumb is that you can safely withdraw 4% of your retirement income per year if you hold 60% of your retirement funds in cash and 40% in intermediate bonds. This rule of thumb was established by William Bengen, a financial planner out of California, after studying various 30-year periods of investment returns. It’s since been refined by other retirement planning studies but the general framework still applies.
There are other, more complicated plans being promoted by investment banks. These often happen to be good for business, because you’ll need a financial planner to keep track of it all, and that comes with a hefty price. Remember what I said about investment firms making things as complicated as possible to promote business?
Complicated doesn’t always work better, and quite frankly, complicated typically performs more poorly than a well-thought-out but simple plan. This is because the complicated version leaves more room for errors and tends to assume that the past will be representative of the future, which is always true – until it isn’t.
What you will find in real life is that the biggest determinant in how much money you can withdraw each year from your retirement fund will be dependent on when your retirement starts and your asset allocation. That’s why the model portfolios and the first investing strategy for retirement that I present to you in this book are so vitally important.
If you were lucky enough to retire in the 1980’s you had a long 20 year bull market during your retirement years in which stock prices continually increased until 2000. If you took out 4% a year you were able to sustain and possibly increase your retirement lifestyle.
On the flip side, those folks who were unlucky enough to retire in 2000 saw their retirement incomes plunge because of the devastating dot com stock market crash. Many are just now beginning to get back to even in the stock market.
If you started your retirement in 2008, you also were quickly hit with a huge loss in the stock market. This put a drastic cut into the amount of money you would be able to withdraw using the 4% rule, or any rule for that matter. Without going into the math, it’s easy to see that the less you have in your retirement fund, the less you can safely withdraw for living expenses.
If you retired in 2009 the story was much different. Your retirement funds quickly escalated if you had the right exposure to stocks. Many retirees could meet living expenses simply on the stock market gains without tapping into the principle of their retirement account.
The bond market itself has been in a bull market the last 30 years. Eventually that will come to an end as interest rates will assuredly have to increase at some point hurting bond investments. We could also potentially run into high inflation like we did in the 1970’s. There’s no reason to fret about it though.
As you will read under the Portfolio Rebalancing lesson, it is pure folly to try to predict the future with any degree of accuracy. It will only end up costing you money. Your best protection is a good diversified investment plan which I will outline to you as we go along.
The bottom line is that retiring is always risky unless you have a defined and guaranteed pension plan backed by the US Government, but even that is coming into question for some retirees. Pension funds are having trouble funding their large pension plans due to the flat stock market prices of the past 10 years and low interest rates of the last 6 years.
A Simple Savings Plan
The first goal of everyone reading this article should be to have enough money set aside to cover unexpected emergencies or job loss. After all, what good is saving money for retirement if at some point, you can’t afford your mortgage payment or to even pay the electric bill?
There are countless articles and books on how to set a budget and save money. What I learned in actual practice, though, is that only a small percentage of the population will actually go beyond balancing their bank accounts to track expenses or use tools like Quicken to track spending and saving. Those people tend to be accountants or analysts by trade who enjoy doing detailed financial analysis.
Therefore I want to present what I think is one of the simplest and easiest ways to put a budget into practice for saving money. Once you accomplish this basic plan, you can then move on to more detailed financial analysis of your spending.
Phase 1: Pay yourself first. Make sure you have enough money set aside for emergencies such as car repairs, medical bills, and other unexpected events. This is the first thing you must do before anything else. Depending on your lifestyle this would necessitate setting aside at least $500 and upwards of $2,000 or more in a savings account.
If you have trouble with this first step remember the foundation of budgeting; live within your means – even if you don’t like it. If you can’t buy something without going further into debt, and it isn’t necessary for your everyday living, don’t buy it. Make the necessary sacrifices to get what you want out of life. Buy a used car instead of a new car, dine in instead of eating out, or vacation in your own state instead of flying out of the country.
During this critical step remember to focus on what’s really important in life. Unless your family was in the upper echelon of earnings, you probably didn’t have a lot of money to spend in high school or college. Sure, it would have been nice, but it wasn’t the most important thing. As long as you had good friends around, you were happy.
However, during your working years your focus tends to change, as free time is minimal and the stresses of life and responsibility start to take their toll. Your focus changes to owning houses, nice cars, eating at nice restaurants, taking vacations, and raising kids.
Be careful not to get sucked into the trappings of owning too many things, or they will start to own you from both a time and money perspective. In the end, it’s family and friends that are most important.
Now that that’s out of the way, let’s go over a simple budgeting plan that’s easy to follow and to put into practice. It’s one that I’ve found people will actually follow once they have enough money set aside to cover basic living expenses and emergencies.
Phase 2: If you have a lot of credit card debt or other debt beyond your mortgage, start paying it off.
There are two approaches advocated to paying off your debt. The first approach is to pay off the debt that has the highest interest rates because that will save you the most money. The second approach recommends paying off your smallest debts (smallest dollar amount) first because they’re easier to pay off.
TIP: While the first approach is the most fiscally sound, studies have shown that paying off your smallest debts first leads to greater success. By paying off smaller debts first, people feel a sense of accomplishment, and are thus more likely to continue paying off debts.
Phase 3: Put 5-10% of your paycheck towards personal savings until you have about six months of income saved up. This savings account will offset the income you would lose in the event that you get laid off or lose your job. If you’re not able to do this, you may have to take a second job, find ways to cut down on expenses or plan on working longer before you retire.
Phase 4: Work your way up to putting 10-15% of your income towards your retirement fund on an automatic monthly plan (more if you have to make up time for not saving earlier in your career.) If you always do this from the beginning, you won’t miss the money.
If you follow this step to the best of your ability during your early years of working and follow a proper investment plan such as the one I’ll lay out for you, you will have enough to retire on and then some if the investing returns stay near their historic levels. I realize it’s hard to do this when you’re first starting out, or when you’re raising a family, but unless you’re working for the government and receiving a generous pension plan, or you become a highly paid executive later in life, you’ll regret not saving what you can earlier in your career.
Phase 5: Decide what you’re able to give charity, and set that up as an automatic monthly payment.
Phase 6: What’s left over after you pay yourself and pay your bills is what you get to spend on entertainment, travel, and the extra pleasures in life.
If you follow the above steps from a young age, you will be financially worry-free, barring unexpected events.
A quick note; I realize that not everyone will be able to meet all of the above goals at one time. You may have to set aside 5% in phases 3 and 4 as you start out, or it may take a couple years just to get to step 3. I know, I’ve been there.
The key point is to do the best you can and make the right decisions while not forcing yourself to live like a monk.
Here are some additional resources to help you out.