Intelligently planning for retirement is much like training for a marathon. Before jumping into investing, it is important to develop a goal for how much you want to have accumulated by the time of your retirement. From this goal, you can determine a yearly savings target and a five-step plan for how much money to invest in each account.
Investing as a Marathon
Running a marathon-a 26.2 mile (40km) road race-is a serious effort that might seem masochistic to most. Yet millions of people are drawn to these races every year, often embarking on months-long training programs that call for them to gradually ramp up the miles they run every week from 20 to 40,50 miles, or more. One of the things that makes training for and completing a marathon so compelling is that there is a clear and concrete “goal post” at the end of the process. Conversely, the lack of a clearly defined goal post is one of the things that makes retirement planning so frustrating.
The equivalent of the “marathon day” for retirement planning is your expected retirement date. By the time of your retirement, you should have accumulated enough savings to comfortably last you through your senior years. Unlike a marathon, however, retirement has an unknown finish line. Figuring out how much you’ll need to live the way you want to is a challenge, but coming up with some kind of goal is essential to designing a “training plan.” The exercise in the following section will help.
How Much of a Nest Egg Do You Need?
Estimating the size of the nest egg that you will need to accumulate to live comfortably during retirement involves two major steps. You will have to first assess the amount of income you will need in retirement and then estimate how much of your wealth you will comfortably be able to withdrawal every year.
Estimating the Income You Will Need in Retirement
- It is useful to consider first the minimum amount of income from your investments you would be comfortable living on in retirement. From this, you can begin to think about the amount of money you will need in your investment accounts at the time of retirement. When thinking about your minimum, or base, annual retirement income target, consider these questions:
- How much money are you spending today? This can be a good starting point for what you will spend in retirement.
- Do you anticipate having lower expenses in retirement? For instance, will you downsize to a smaller home? Pay off a mortgage? Spend less on children? Most people can get by on 2/3 of their current income and spending because they will have fewer expenses in retirement.
- Do you or your spouse have a pension plan from a company or the government? Do you anticipate holding a part-time job after retirement? Are you the kind of person that is going to keep working long past 65? Subtract from your figure any additional sources of income you anticipate having in retirement. Consider how much you are projected to receive in Social Security benefits (you can find this on your last Social Security statement).
- It is important to note that this does not have to be an exact exercise. Whatever number you come up with, write it down-you will use it in the next step.
- Next, consider stretch goals and the income needed to meet them. Have you always wanted to travel the world? Buy a yacht? Take a cruise? Just live a more luxurious lifestyle? Write these down and estimate the amount of money you will need to accomplish these dreams in addition to what you will need to cover basic needs. Add this sum to your total from above to get a stretch retirement income target.
Estimating Your Safe Withdrawal Rate
Now that you know what the target income is, the next step is to figure out the total savings you will need at retirement to produce it. In retirement, you will continue to invest your nest egg in the markets so that it continues to grow while you withdrawal some money every year to cover your living expenses. The goal is to have a portfolio that will last 25 years or more after retirement (the typical retirement lifetime).
How much of a portfolio can be safely withdrawn every year is subject to fierce debate, and depends on all kinds of assumptions about inflation, interest rates, and future investment returns. In general, the experts agree that
- If you are very concerned about outliving your assets, have little room to adjust spending in the event of a market downturn, or just want to be extra conservative, a 4% withdrawal rate will protect your assets in all but the very worst bear markets.
- Many people should be able to withdraw 5% of their assets during retirement (this assumes a relatively modest 2% rate of return after inflation over the retirement period).
- If you have significant flexibility to adjust your lifestyle in the event that returns are lower than expected, you might be able to withdraw money at a 6% or 7% rate instead.
To determine the amount of retirement wealth you will need to produce your stretch and base cases, divide the annual target income by the withdrawal rate that’s best for you. For instance, if you need $50,000 per year in retirement income (in today’s dollars) and have a little flexibility to adjust your lifestyle in the event of a market downturn, then you will need $50,000 / 0.05 = $1,000,000 in savings at the time of retirement. If you require only $20,000 in addition to your other income sources such as social security, and you have great flexibility to adjust your income, then you may need to budget only $20,000 / 0.06 = $330,000 as your end goal. Perform this calculation for both your stretch and base income goals.