This is a question that I hear regularly from the baby boomer generation now they are edging toward retirement. Of course, what we all actually mean when we ask the question is ‘how much do I need so that I can live the rest of my life in comfort?’
It is, in reality, an almost unanswerable question. There are so many unknowns that need to come into the equation that the best we can do is look behind us in order to peer into the future.
What we all wish we knew
According to the US Labor Department, inflation cost 39% of purchasing power in the twenty years between 1991 and 2011. In other words, $100 in your pocket in 1991 would only be worth $61 now. Put another way, to buy the same amount of goods today as you could with $100 in 1991 you would need $163. Just imagine having retired in 1991 on a fixed income, and trying to survive now on the same number of dollars in your pocket as you did back then.
Many retirees purchase annuities to provide income in retirement. These pay income on a regular basis, and can be structured so that the income increases in line with inflation.
However, the rate of return depends upon interest rates – as well as a number of other factors – at the time the annuity is purchased: when interest rates are low, so too is the return on an annuity. Unfortunately, we don’t know what returns will be when we retire. If a return of 5% is paid on an annuity and you require $50,000 per year to live on, then you’ll need a pot of $ 1 million to purchase that income producing annuity.
Others rely on the return on investments that can be achieved from a portfolio of stocks and bonds. Prevailing rates of return are the key here. Stock dividends of around 2% have hardly been enough to produce great returns over the last 10 years or so while major stock market indices have stagnated. Meanwhile, yields on corporate and treasury bonds are at historic lows.
If you assume that inflation averages around 3% over the next 20 years and your portfolio returns 5% per annum, according to BTN Research you’ll need a lump sum of $196,000 for every $1,000 of monthly income you need. If you expect to live 30 years in retirement, this number goes up to $269,000. So if you want $10,000 per month through 30 years of retirement, you’ll need $2.69 million when you retire.
So, there are many variables that we need to take into account when we are planning for retirement, almost all of which we can only guess at until retirement is upon us.
Other things to consider
How long do you plan to live in retirement? This may sound like another unanswerable question, but you have to have a basis on which to invest for your retirement and this is the first call you need to make. The longer you expect to live, the more money you’ll need to produce the income you need – planning for a lifespan after retirement of 10 years, and then surviving 20 will be catastrophic to your later life finances.
Social security payments are wide ranging at the moment. But that doesn’t mean they will still be available in 10, 20, or 30 years’ time. Social security is an unfunded program, paying benefits out of taxes collected from workers. In the future there is likely to be fewer workers supporting greater numbers of an aging population.
At present day demographics, there are around 7 workers supporting each retiree. It’s estimated that by 2050 this ratio will be down to 2:1. With numbers like these, it really is best to discount any potential social security benefits available in retirement, because they probably won’t be.
If you have a lump sum at retirement and invest in the investment markets, your return will be based upon the price of the market when you invest. What this means is that if you invest when the markets are low, your investment returns will be higher than were you to invest when the markets are high. Timing of investment is crucial when it comes to retirement.
So, how much do I need to retire?
It would seem that the answer to this question is a constantly moving target. There are so many variables and so much uncertainty, and none of us have a crystal ball. But all is not lost, because there is one way to accurately answer the question how much do you need to retire:
You need enough to be able to live.
Consider this. If you spend $570 per week, or approximately $2500 per month, you’ll need about 25 times this amount to generate the income you need through your retirement. This is based upon the rule of 25, which says a realistic long term return of 4% on investment can be achieved (after inflation of 3%).
So, if you spend $30,000 per annum ($2500 each month) you’ll need a pot of $750,000 to satisfy this requirement. But, if you can reduce spending by $1,000 per month then you’ll need $300,000 less. Reducing expenditure has a massive payback.
Or you could use the 4% rule
The 4% rule says that you should withdraw 4% of your retirement fund in year 1, and then follow that by increasing for inflation every year thereafter. This rule also assumes a 4% real return, just like the rule of 25, but gives an increasing amount of income.
You only have to calculate the 4% in the first year, and then each year you adjust the amount withdrawn for inflation. Assuming you have $750,000 in your retirement pot when you retire, your first withdrawal would be $30,000. The following year, if inflation is running at 3%, you would withdraw $30,900 irrespective of investment performance.
Of course, this might be more than 4% of your portfolio should your investment perform poorly: but sticking to 4% rule means you don’t need to worry about this. Or, at least, that’s the theory.
The real answer to how much money to retire is needed is, in truth, as much as possible. For those of us that fall short of this ideal, then a certain degree of budgeting will be necessary.
But perhaps the secret is to begin planning as early as possible toward happy years in older age, making the most of pension investment opportunities and tax breaks as we work, and save, toward a long, healthy, and wealthy retirement.