The question is simple enough, but it can be quite a difficult one to answer. And that’s primarily because the answer typically depends on such a wide range of variables and assumptions. The result is that many of us simply avoid the question – but as we all know not asking the question doesn’t solve the problem.
There are many different approaches to determine how much money you will need to retire and none of them are right. They are all nothing more than an estimate and in some cases not much more than a guestimate. Some approaches are quite scientific and others are not much more than using a simple rule of thumb.
The main thing is that you need to be comfortable and confident with how you plan for your retirement, but you do need to be realistic and take into account some key issues many people forget or simply ignore, like healthcare or the issue of inflation.
So in this article I will look at the 3 basic questions you need to answer to determine how much money you need to retire, these are:
- How long will you live?
- When do you want to retire?
- What level of retirement income do you aim for?
There are many more issues that can come into play like inflation, how risk averse you are, what tax structures you have in place, what level of insurance do you need etc. but those can all be dealt with at a later stage. After we have the three basic questions answered we’ll look at some of the common approaches to determine how much money you’ll need to stash away.
So let’s start.
How Long Will You Live?
Easy question and if you want to give an easy answer you just use the current life expectancy, so in Australia that is 79 if you’re a man and 84 if you’re a woman (based on ABS Life Tables, Australia, 2006–2008, 3302.0.55.001, updated in December 2009).
Personally I am an optimist and I also like to be conservative so I simply use 100 in my own calculations, but being too conservative is not advisable either as you’ll end up working / saving too long. So when we get close to our retirement target I might just bring that expectation back to statistical reality.
Then again, studies in the US show that life expectancy might well just reach 100 years of age by 2030! At least, that is the claim of Stanford University biologist Shripad Tuljapurkar, who bases his finding on biological advances and anti-ageing technology. If Tuljapurkar is right, then many people now in their 50s will live to at least 2050. If they were to retire at age 65, that means 35 years in retirement. Then it’s not just a question of having enough income each year during your retirement, but a key concern is whether you will outlive your retirement savings. We’ll cover that later.
For now let’s just run with the average life expectancy so we can determine how long you will be living without a regular income and that brings us to the next question.
When do you want to retire?
All you need to give is a simple number: 60, 55, 50 or even 45. Start with your ambition not what you think you might manage or what people around you would expect you to do. This is you life so you need to decide. Love your job? Then 60 might be just fine for you. Some of us, have held down a job which hasn’t done too much for them other than pay the bills so they may well want to get out early. 50 anybody?
Really there is not much more to it at this point, just pick an age. Once you start crunching numbers you’ll soon enough see if you need to adjust the age, your lifestyle expectations or in some cases both.
Bummer.
To avoid too much frustration do start with something challenging and reasonable. If you’re 35, have piles of bad debt, no savings or investments aiming for retirement at 45 is unlikely to work unless you aim for an extreme adjustment in your lifestyle or are expecting a windfall.
What level of retirement income do you aim for?
This is where you really need to sit down and start doing some homework. It’s easy to say I want $100,000 a year, but in many cases that won’t fly. I would recommend you do two things at this stage. First you use a simple rule of thumb to determine your required retirement income and after that you sit down and develop a detailed annual budget. Put the two numbers together and you can come up with a reasonable first estimate.
So, first we apply the general rule of thumb, which says that the income you’ll need in order to be “comfortable” when you retire is between 65% and 70% of your pre-retirement income. This figure was first set by a Senate committee looking into the adequacy of retirement savings in Australia. The figure has since been adopted by industry bodies, financial planners and the media – in other words all the “experts”.
Bear in mind that the higher your pre-retirement income, the higher the retirement income you’ll need. And the higher the income you need, the more capital you need to accumulate before you retire. If your income in the years before you retire is, let’s say, $100,000 a year, then a “comfortable” retirement according to the generally accepted view is something between $65,000 and $70,000 a year.
In my personal view, the 70% rule of thumb is way too crude and this is why I’m suggesting you should do a bit more homework and develop an annual budget. If you don’t and simply go blind on the 70% assumption you risk either working till you die as you’ll never be able to afford your unreasonable lifestyle expectations or you’ll suffer a far from comfortable retirement, 20 years or so at the poverty line.
Remember, I am writing this article with a view on retiring early, nothing extreme but simply with the intention of escaping the rat race a bit earlier. And the art in retiring early will be achieving a balance between the lifestyle you want and the money you have. The more you want the later you can retire. Keep that in mind when you develop your annual budget.
When you develop your annual budget think about: food, accommodation, transport, regular household costs, health insurance including allowances for excess health costs, life insurance, travel and of course leave some money for having fun and just discretionary spending! Add to add anything ‘unique’ like whether you still have kids at uni, have an ex with kids to support etc.
And don’t forget the taxman!
Calculating how much you need to retire
Now that we have the basic questions answered we can crunch some numbers. And to make things a bit easier to follow, let me introduce you to Jake and Helen. They are both 38 years old and have a combined income of $100,000 a year. Their ambition is to retire at the age of 55 and having done their homework the believe they can live quite comfortably off $55,000 a year, but they also know that they want to do a lot of travelling in the early years of their retirement so they’ve increased their desired income to $70,000 per year. To keep things simple they assume a life expectancy of 85 for both.
Now the question is: how much do they need to retire?
A simplistic approach would be: 30 years of retirement from the age of 55 till 85 at $70,000 a year would require Jake and Helen to accumulate a nest egg of some $2,100,000.
Ouch.
The ‘true’ situation is a little more complicated than that and possibly a bit less daunting. Remember, when you stop working your money should continue to work for you assuming you have invested it wisely. On the flip side you also have to allow for your worst enemy when it comes to retirement planning and that is inflation. That $70,000 might be fine in today’s money for Jake and Helen to do what they want to do, but by the time they retire in some 17 years that same $70,000 will only be worth around $41,000 in today’s money. When Jake and Helen are 75 that $70,000 will buy them less than $23,000 worth of goods and services in todays prices.
And this is where the complications come in.
First of all you need to estimate at what rate your investments will continue to grow whilst you are retired. Secondly, you need to allow for a certain amount of inflation. Thirdly, you do need to realize that your living expenses tend to be highest in the early years of your retirement and then gradually reduce as you age. Your healthcare costs on the other hand are likely to increase as you get older. Bottom line is, your retirement income needs won’t be constant from year to year. So that’s another factor that complicates the calculations.
At this stage a financial planner can be an invaluable ally when it comes to working out things like this. However, in my experience most retirement advice is too simplistic and does not account for the fact many of the variables like investment returns and inflation will go through big variations during your retirement. If you are lucky enough to retire with a full nest egg and encounter 10 bull years on the stock markets you’ll be fine, but if you’re unlucky enough to encounter the worst bear market in a century when you’ve just gone into retirement you may well have to come out of retirement before the first few years are over.
Doing these calculations can become very complex, and so the industry has established another rule of thumb, which suggests that it would be safe to withdraw 4% of your next egg each and every year without running the risk that in the last few years your bank account would be empty. This 4% is sometimes also referred to as a safe withdrawal rate. It basically means that if you have $1,000,000 invested you can spend $40,000 a year – each and every year, whether it’s a bull or bear market as over time they will even out and your initial $1,000,000 will remain intact.
So, for Jake and Helen who wanted to retire at the age of 55 and expected to live another 30 years with an annual income of $70,000 they would require a nest egg of $1,750,000. Still a very sizeable chunk of cash, but nonetheless it is some $350,000 less than the initial calculation we made.
Various people have looked at this subject in great detail and have actually done statistical simulations based on actual historical investment returns etc. to see whether this 4% safe withdrawal rate is indeed safe enough. There are no easy conclusions, but some key warnings are put forward. Firstly, the 4% withdrawal rate might be too optimistic if you retire young or end up living very long. Secondly, some argue that investment returns are coming down and as a result a withdrawal rate 4% could not be deemed safe anymore.
Most of these studies are based on the performance of US stocks and they have indeed not performed well in the last decade and are unlikely to be your best for good growth for the coming decade. So maybe it’s time to consider other markets or other asset classes like property. Personally we have invested in Australian Real Estate and have kept a portfolio of (index) funds on the side, which I do expect to grow steadily over the coming years.
So, how much do you really need to retire?
By now, you must see there is no simple answer to that question. But if you insist, I would say that the 4% rule is probably the best place to start with. However, I’d strongly encourage you to read much more about the various aspects of retirement planning which I have only briefly touched upon here. Then over time you can figure out what you will feel confident and comfortable with.
Good luck.
