How Much Do I Need to Retire?

How much do I need to have saved up to retire?

This is the age-old question that has been plaguing both me and the general population for decades. Before we can delve into this, let’s first figure out what it means to be “retired”.

How Much Do I Need To Retire

What Does Retirement Mean To You?

This is the age-old question. The definition of retirement is as vast and varied as the people asking the question. This is because retirement means different things to different people. For some, it means to continue working in an area of interest that was not what they did for their career.

For example, I knew this woman at work who was pretty high up at my company (near executive-level). She retired after 30+ years with a full pension, healthy 401K, personal investments, and management perks (think free car for life…. seriously!). Most people would stop working, relax, eat bon-bons all day, and see the world.

Not her. What did she do?

She became a licensed real estate agent and currently sells high-end homes (>$1M) in Florida! Why? She didn’t need the money……. It was because she wanted to try something new and different. She didn’t need to work but she finds fulfillment in working…… That’s ok.

For others, retirement has other meanings. It may mean to volunteer in their free time and give back to their community. For others, they may have an entrepreneurial bug and always wanted to build their own brand. Still others, they may just want to sit on their ass all day and watch the grass grow!

For retirement, all of these choices are acceptable and ok to do since it is about what YOU want! There is no wrong answer.

Investopedia’s definition of retirement is “the time of life when one chooses to permanently leave the workforce behind. The traditional retirement age is 65 in the United States and most other developed countries, many of which have some kind of national pension or benefits system in place to supplement retirees’ income.”

Do you want to know what my definition of retirement is? My definition is when my passive income equals expenses. This is also the definition of financial independence for some people. I want to be able to choose when I wake up in the morning. I want to choose how I spend my time. I want to choose how I live my life. I want freedom! 😊

I’ve set a goal that 10 years from now to have both over $1M in retirement assets AND to have enough passive income generated to cover my living expenses. In other words, I want to retire and be financially independent!

Putting this in writing feels good. It feels good because the idea is transforming from a goal to a promise both to myself and to you that I plan to keep.

What Questions Do I Ask?

How Much Do I Need To Retire

The real questions that needs to be asked to define retirement is:

What does “retirement” mean to me?

What do you want out of life when your career is over?

What promises will you make to yourself to get there?

Do I want to continue working? Become an entrepreneur?

What will I do with all that free time? Travel? Spend time with grandkids? Watch grass grow?

I can’t answer these questions for you, only you can. Put some thought into what you want from retirement before actually retiring. Too often, people who have worked their entire lives put no thought into life after working.

When retirement comes, these people feel like they have lost their sense of purpose, their identity. Don’t let this happen to you. Put together a plan for life after working and what would bring fulfillment to you once your career over.

Traditional Method To Calculate Retirement Income

Once the question of what retirement means to you gets answered then come the next part:

Figuring out how much it will cost and how to pay for it?

The way most people calculate retirement is to use the 80% Rule. This rule is as follows:

You need 80% of pre-retirement income during retirement

There are several flaws with this general rule of thumb and, IMO, is not a reliable estimate. Here’s why not to use:

Difficulty in Accurately Predicting Income

Making assumptions of how much income a person will have at retirement is extremely difficult and unpractical. The reason is careers can fluctuate and so do incomes. Incomes can go up or down in relation to their careers.

Incomes can struggle for years and then poof, 3 promotions occur in 5 years and your income grows 75%. While this is great for your career, how does a person plan to hit this moving target?

On the flip side, people can experience demotions or changes to lower paying careers that can significantly impact income. Predicting income level near retirement is difficult to say the least.

What about high-income earners? If earning $200K or more per year right now, is it realistic to assume you’ll need that much during retirement? Probably not. Here’s an example, assume a couple is making $250K annually at retirement age. This means that this couple will need over $6M saved to retire comfortably using the 80% Rule (250,000*80%*30-year retirement). Do you think they will really need $6M? Probably not.

While it is good to have a surplus of funds for a healthy margin of safety, a target that seems too high may be perceived as unattainable and frustrate the retiree. You need something realistic that also has a margin of safety.

Here’s another example. I have a friend who is currently “retirement-eligible” and will probably retire soon (3-5 years max.). He just received a demotion at work and lost 20% of his salary. 20%! Luckily, between his pension and retirement fund is covered for his golden years.

Unfortunately, he is struggling to adjust to the new income and contemplated dipping into investments now until he retires. He has even talked about extending his working years. He fears that he now must dip into investments so much to maintain his lifestyle that it will force him to delay retirement in order to recoup lost earnings.

Doesn’t Take Inflation Into Account

Inflation is the killer of retirement savings. We have been very fortunate to have low inflation for the past several decades as the graph below and in this article shows. We have had inflation below 5% since the 80’s and even lower past the year 2000.

How Much Do I Need To Retire

Give how high the National Debt is growing every day and the new monetary policy the Fed is enacting, it is only a matter of time before inflation starts to increase and maybe significantly.

Why care?

As I talked about in this article and in this article, inflation is the decline of a currency’s purchasing power over time. In other words, the same amount of money buys less goods and services over time.

How this impacts retirement is that the higher inflation gets, the more money needs to be spent to buy the same amount of product. For example, let’s assume you budgeted to spend $80,000 (80% of $100K) assuming the inflation rate back in 2001 of about 2.85%. If in 2021, the inflation rate jumps to 4%, the $80,000 budget cannot buy anywhere near as much product as originally intended. The consequence is that more money will have to be pulled out of the retirement funds to compensate. Not a good situation.

The 80% Rule doesn’t take the impacts of inflation into account and this flaw can really impact a person’s retirement. Instead of celebrating all those years of hard work, the golden years can become more stressful than necessary.

Doesn’t Accurately Predict Expenses

The 80% Rule has some general assumptions to it:

  • Assumes mortgage is paid in full
  • Assumes credit card debt is paid off
  • Assume kids are out of college and living on their own.

Here’s the sad reality. According to this NerdWallet article,  37.6% of households age 65 to 74 and 27.7% of households over the age of 75 have a mortgage. And large mortgages to pay off to boot. This is up drastically from 30 years ago.

Also, people are starting families later than ever. It is not uncommon for couples to start having children into their 30’s and continue into their 40’s. Compound this with the skyrocketing cost of a college education, it’s no wonder children are staying at home longer than ever.

I remember when I was 18 and getting ready to go to college. I was in a 3-point stance ready to run out the door to start my life and didn’t look back! 😊

Not so much anymore, for today’s generation to pay down college and save for their 1st house, it is not uncommon to live at home well into their late 20’s. A good friend of mine has his college aged son living at home to save money for college. He says his son plans to live with them well into his 20’s because “owning a house is expensive” (Duh? 😊). It was one of the reasons they decided to buy a much larger house (huh?). Compound that with also paying more in groceries and utilities and it’s no wonder people are struggling to save for retirement well into their 50’s and beyond.

Another sad fact. People woefully underestimate medical costs and long – term care expenses. A recent study estimated that the average couple will spend $295,000 in medical costs during a 30-year retirement…… $295,000! This is a mortgage payment!

Even worse, long-term care costs currently are on average nationwide about $100,000 / year and climbing. If a couple needs long-term care, even for a few years, it can wipe out a lifetime of hard work. Fortunately, there are ways to mitigate long-term care expenses that I discuss here. Check it out!

Doesn’t Take Taxes Into Account

Taxes. That dreaded 5-letter word that makes most people cringe. Guess what? Here’s another reason to cringe. The 80% Rule doesn’t consider the taxes paid out in retirement.

The 80% Rule was devised assuming a person could live in retirement on 80% of their pay. Never did it factor in taxes. Surprised? Don’t be. Unless your entire 401K is in a Roth IRA or Roth 401K, a person will be paying taxes on the withdrawals.

How much? Let’s find out. According to Investopedia, there is a mandatory withholding of 20% on a traditional 401K withdrawal to cover federal income taxes.

Using the 80% Rule and assuming pre-retirement income of $100,000, a person would withdraw $80,000. Do they get $80,000? Nope. That person only receives $64,000 because of taxes ($80, 000 – $80,000*20%). Your $100,00 pre-retirement income jut went down to $64,000. A 36% decline!

How Much You REALLY Need to Retire

Before we can answer this, we first need to understand how to calculate retirement expenses. Why? Because this will tell us how much is needed to live on in retirement.

How Much Do I Need To Retire

Figuring out expenses for retirement may sound overwhelming so let’s break it down:

  • Understand What You Want in Retirement

As I talked about previously, the 1st thing that must be done is to understand what your vision of retirement is. Do you want to travel the world? Do you want to be an entrepreneur? Do you want to sit on your ass all day and watch the grass grow? All are good and valid visions of retirement.

Understanding your personal retirement vision provides direction. It doesn’t lock you in. It just provides a guiding light, a North Star to start the journey. It’s ok if the vision changes in the future.  This exercise is to just get you started on the path.

For example, I plan to do a lot of traveling both locally and internationally when I quit the workforce. I want to see all the places I have read about over the years and have not yet had a chance to visit. I plan to spend a lot of quality time with my grandkids, going to their games and recitals, and teaching them all the things I wish my grandparents taught me. I plan to start some hobbies. I always wanted to learn to play the guitar and drums so will probably take it up in retirement. Never too old to learn something new! 😊  This is my heaven.

  • Create Retirement Budget

This is going to be a 2-part exercise. I know budgets can suck but they are important.

1st off, knowing daily expenses is needed to understand where the money is going. Be brutally honest about your situation. It will help to setup future success.  For example, track not only the mortgage, student loans, credit card debt but also subscriptions, gym memberships, lunch money, entertainment, etc.  Make sure every dollar is somehow accounted for.

Next, create a retirement budget. Use the assumptions made about your retirement lifestyle. Will you have a mortgage? If yes, budget it in. If no, make sure to still budget in taxes and insurance. Even if the mortgage is paid off, taxes and insurance are still due. The government always wants their cut of the action.

If assuming that all credit card and student loan debt is paid off, then reflect this in the budget.  Follow this exercise for all expenses to determine if in or out of the budget.

For expenses that are variable or expected to grow over time, modify using the Rule of 72. This is an investing rule that we can modify to use for this purpose. It simply states that in order to find out how long it takes for money to double in size, divide the expected rate of return by 72. For example, if the expected rate of return is 8%, money will double in 9 years (72/8 = 9 years).

I used the 100+ year historical inflation rate of 3.22% to set how many years it will take for the expense to double in size. In this case the expense will double in size every 24 years. Also keep in mind how long it will be before retirement starts. I use the standard retirement age of 65 to set my retirement horizon.

Here is an example of how to use this method for calculating variable expenses. Assume a person is 41 years old and has 24 years until retirement. If the current food budget (includes eating out) is $500 per month, in 24 years, assume the food budget to double to $1000 per month.  Do the same thing for a lease car. If the current lease budget is $400 per month. In 24 years, double the lease budget to $800 per month.

These costs may seem excessive but look at the rate costs have grown just in the last 10 years. For example, a value meal at McDonald’s used to cost about $5 around 10 years ago. Today, the average price is $7-8.  Plus, it is better to overestimate costs and deliver on income than to underestimate and be short on covering living expenses. Remember, always build in a margin of safety when possible.

For fun money, assume what would be spent today for travel, hobbies, etc. For example, let’s assume $5000 per year is spent on vacations, getaways, season tickets, and overall entertainment. In 24 years, double the budget to $10,000 then divide by 12 months to budget $833 per month.

Unsure what fun you want to have in retirement? Budget an extra 15-20% on top of living expenses until this is figured out. Remember, all the answers are not needed right now, but a starting point is needed. It’s ok to change course as the journey progresses. Be flexible and adapt as needed. This exercise is to find a North Star and get started on the journey.

  • Figure Out Cashflow and Net Worth Needed

Now that the annual expenses needed in retirement is sorted out, how to fund retirement needs to be figured out. The cashflow needed is simple to calculate: cashflow = expenses. The goal in retirement is to cover all expenses. If you have surplus money leftover each month that is great for you! At a minimum, you need enough cashflow to cover expenses.

To figure out net worth, take the amount of cashflow needed and divide by the expected investment rate or return.

This is different than the 4% Rule. The 4% Rule is a withdrawal rate used to understand what you have to live on in retirement and THEN set the budget.

My rule is used to calculate how much net worth needs to be accumulated to meet and sustain annual cashflow needs that cover budgeted expenses. This is the polar opposite of the 4% rule.

Use a rate of return that is easily achievable yet realistic. Most people use the T-Bill rate for risk-free rate calculation. Unfortunately, the current rate is 1.7%. I’ll use a different rate and explain how I chose it.

Here is an example:

Let’s assume the annual expenses at retirement is calculated to be $100,000. If the rate of return on investments is assumed to be 5%, a $2M net worth is needed to sustain retirement ($100,000 / 0.05). 

Why use 5%? In place of the T-Bill rate, I substituted the rate I would get if I invested all my money into a whole life policy. I could make regular withdrawals via tax-free loans against the policy and still have the balance grow at a rate of 5% risk-free. A whole life policy is a legal contract between the insurer and policy holder that is not tied to the stock market.

If not comfortable with this rate, choose a rate you are comfortable with. I would go on the low side (under 6%). This should be worst case.

This rate is the “floor” or absolute minimum amount of money needed to retire. I recommend adding a 30% margin of safety to this number to find the optimal net worth needed to retire. Referring to the example above, adding a 30% margin of safety to the $2M net worth and the optimal net worth is now $2.6M.  This should be the target number to achieve. This optimal net worth gives you some cushion in case the calculations are off, protects against taxes, or if life just happens.

Remember, this a directional number and may change as new information comes in and adjustments are made. It is better to go high now, budget to meet it, and then lower expectations later rather than the opposite happening.

These calculations assume a person is not getting a pension, an annuity, or social security. Why? Because this is worst case. Pensions can be taken away (look at Kodak) and people are becoming more concerned that social security may not be there for them when it is time to retire.

The best way to budget is to assume it is not there. If social security or pension payments do occur, then GREAT! More $$$$ for you! However, if you find out at age 64 that social security went defunct then you’re screwed! This is a HUGE hole to fill at that stage of the game!

If truly confident that your pension, annuity, or social security will be there when retiring, calculate how much this will be on a monthly basis (including deductions for taxes, assume 30% tax rate) then subtract this from your expenses. Next, use the uncovered expenses to calculate how much cashflow is needed and subsequent net worth.

I provide a tool here that can be used to develop a retirement budget. It can be customized to suit individual needs.

Off Into the Sunset of Life….

The goal of this exercise was to get you thinking about retirement, what it means to you, and how much you’ll need saved in order to live the life you want. Use this to find your North Star and a direction to pursue.

How Much Do I Need To Retire

Remember when planning for retirement, use the worst-case scenario and take taxes into account. We are at historically low tax rates so assume we will pay more in taxes in the future.

This isn’t easy at first and take practice to understand the big picture. It’s like trying to hit a moving target that is also swerving and dodging. Review the plan annually and adjust when necessary. At first, it may seem daunting but the more it is practiced, the easier it gets and the clearer the picture becomes.

As Lao Tzu said, “The journey of 1,000 miles begins with a single step.”

Live the Life You Love, Want, and Deserve! 😊