How Much Do I Need to Save for Retirement?
Everyone knows that they need to save for retirement, but most of us don’t really know which magic number to shoot for. Our goal should be to meet our financial needs in retirement and not run out of money. When you don’t know what your target is, your saving efforts will probably be wishy washy. This article presents a simple process to figure out how much you will need. There are 3 easy steps. You can choose to get complicated with this, but simple is best. This should only take you about 15-30 minutes.
1) Annual Expenses
The first step is to calculate your annual expenses for your first year of retirement. I will present the most conservative way to do this. You can use this budget calculator to determine that. Here’s another budget calculator. Calculate what you expect your expenses to be using today’s costs. Don’t get too caught up in detailed estimates. Quick estimates will suffice. Once you have your expenses calculated, then you go to an inflation calculator or this one and estimate how much inflation will increase that amount.
So if you would need $40,000 in today’s dollars, then in 20 years with 3% average annual inflation, you would need roughly $72,000. Using 3% for inflation is pretty standard. You can always use a higher number if you feel that inflation will be higher in the future. Remember to calculate in any income you think you may have such as investment income, pensions, and social security. This will lower the amount you will need.
2) What Size Portfolio Will I Need? Try The 4 Percent Solution.
“The 4 Percent Solution” is the answer to “How do I ensure I won’t run out of money in retirement?” Based on a Monte Carlo analysis, “The 4 Percent Solution” states that there is a high probability (90% confidence level) that you can maintain your lifestyle during a 30 year retirement with a portfolio that is 25 times the size of your first withdrawal. Don’t worry if you don’t understand that. All you need to know is that this is a standard way to determine your target retirement portfolio amount.
So here’s how you use this. Take the annual expenses you calculated, $72,000 in our example, and multiple by 25. So in our example your retirement portfolio needs to be at $1,800,000. Conversely, if you are close to retirement already and you know how much you have, you can determine the maximum amount that is prudent to withdraw in the first year.
If you have a $1,000,000 portfolio upon retirement, then the maximum you should withdraw in the first year would be $1,000,000 X 0.04 = $40,000. The amount you withdraw each year after that can be increased according to inflation.
If you want a higher confidence level of not running out of money during retirement, you can:
- spend less (best method)
- save more (good method but difficult)
- increase income by working part time during retirement (good method, a chance to try another field of work)
- and/or increase your income by having a more aggressive investment portfolio (risky and not recommended for retirees or those close to retirement.)
3) Create Your Savings Plan to Hit Your Target Retirement Portfolio
Use an investment calculator to determine how much you need to save monthly. In our example, you need a portfolio of $1,800,000 upon retirement. Sounds pretty daunting, huh? Let’s take a look at how doable this is.
Let’s say you start out with a portfolio of $50,000 and that you invest that money in a moderately aggressive portfolio (80% stocks/20% bonds) of index mutual funds for 30 years. (See my Guide to Investing for help with setting up your portfolio ) Let’s assume an annual rate of return of 9%. You would need to contribute $581/month to reach your goal.
Now $580 is quite a bit of money, but somehow many people are able to spend that amount of money and not even realize it. Or how about your car payment, if you have one. For many people, that is a hefty number. But notice how when you really want something, you usually find a way to pay for it. It should be no different with your retirement savings.
Even if meeting your monthly savings target is a struggle, at least you now know what to shoot for. You can slowly begin to take steps to cut back on expenses. Take a look at my post on ways to improve your financial situation for some ideas. You can also play around and tweak any of the numbers in your calculations to make it easier to meet your goal. Save what you can for now and work towards saving the amount you need. You Can Do It!
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