How much do I really need for retirement?


How much do I really need to save ?

Last entry we looked at how and why we need to start saving for retirement early. But how much do we really need? I guess the better question is what do you really need to live on? You may think that a million dollars is excessive, but lets see….

Lots of authors will tell you that you probably will need some fraction of your current income when you retire. The logic is that you wont have children in school, your house will be paid off, you will be spending less on work clothes etc. But what if you buy a second home. Or perhaps you want to travel. Maybe you have started a new hobby with your newly found free time and you incur some expenses. Perhaps you’ll want to help out your children as they embark on new careers and family. You or your significant other could have an elderly parent to take care of. And don't forget – just because you are retired, don't think Uncle Sam won’t be coming for his cut. With people living longer and staying healthier I’m not certain that most veterinarians actually will see a significant decrease in expenses.

For a moment, let’s look at the other side of the equation – our savings. How much of your savings can you take out each year and not run out of money. The answer is “it depends.” Maybe you want to leave some money to your children. Perhaps you want to leave money to a special charity. Assuming that's not the case – how much can you take out of your retirement savings and not run out of cash?

One way would be to take the average life expectancy of in the US which is 81 for females (for men its 76). If we retire at 65 that means we need plan on supporting ourselves for -on average - 16 years. So we could just take our retirement money and divide by 16 and live on that each year. Using our previous example where we saved $1 million dollars, we would get ~$62,000 a year.  Sounds great! – don't do this. This is a terrible plan. For one, thing – the 81 years is an average! One half of women will live longer – and it could be a lot longer. What if you live to 91. That's 10 years with no income. Also, what if you get sick – you could need some of those funds to purchase healthcare or comforts. Lastly, what if your significant other outlives you. You will probably want to be certain that they are comfortable and taken care of (or not :) ).  The long and short is – Don't do this

You could leave your nest egg intact and only take out earnings. That plan probably would have worked out great in 2003 when the stock market returned 23% but what would you do in a year like 2008 when the market lost 37%. Unless you like cold soup and cardboard boxes – you probably can skip this plan too.

This brings us to “the 4% rule.” Essentially the rule states that you can safely take out 4% of your retirement savings each year – regardless of how the market performs. So if the market goes up 23% you take out only 4% and when the market does down 37% you still take out 4%.  Studies looking at decades of stock and bond data show that there has been no period (including the 1930s) when following this rule would result in savings being exhausted in less than 30 years. This is the rule that I use and recommend.

Lets apply the 4% rule to our 1 million dollars in savings. According to the 4% rule you can safely take out $40,000 a year. If we add in social security we are up to ~$70,000.  So you see that the 1 million dollars that probably seemed excessive just a short time ago is actually a realistic starting point.  Did I mention the need to save, save early, save often and save some more?