It may come as a surprise, but no single magic number can guarantee the right amount of savings for a person’s retirement goals. How much a person will need in retirement depends on many factors, including the lifestyle they want to lead, where they plan to live, and how they define comfort in retirement. When we help people save for retirement, we focus on helping them understand their future costs and introducing them to the tools they need to save enough for those expenses.
Breaking Down the Common Benchmarks
A few common retirement savings goals are floating around. Many can be a useful starting point for research and can help estimate what you might need to reach your goals. However, take them with a grain of salt, since no two people have the same circumstances.
The 80 percent rule is possibly the most recognized retirement planning target. It is based on the premise that in retirement you will need to spend only about 80% of the money you were taking home before retirement to maintain your standard of living. This number makes sense for several reasons. For one, you will no longer be contributing to your 401(k) plan at work, so that expense is eliminated. You also won’t have to fund a commute to and from work, so you will save a lot on gas, wear and tear on your car, and public transportation costs. Additionally, many retirees experience a decrease in their overall tax liability as they leave the workforce and enter retirement.
One flaw in the 80 percent rule is that it does not account for major changes to your living arrangements, such as paying off your mortgage before retirement, which can reduce your required income. On the other hand, people who have big plans for retirement such as constant travel, extra homes, or a myriad of hobbies could end up needing 100% or more of their pre-retirement salary during the initial phases of retirement. Therefore, the 80 percent rule is just a guideline and should be considered carefully based on a person’s specific circumstances.
What to Know About the 4% Rule
A further rule of thumb relating to how much it’s thought necessary to withdraw in order to fund a comfortable retirement is the so-called 4% rule (named for the 4% of the initial capital of the fund that it’s thought safe to withdraw each year in year one of retirement, with the remaining capital then being allowed to grow over the subsequent year to compensate for inflation in the following year).
To use the 4% rule for determining how much you need in retirement, you reverse the above equation to get the amount you will need to withdraw in year one of retirement. Then multiply that by 25 to get the total portfolio amount you’ll need in retirement. For example, $60,000 x 25 = $1.5 million.
It sounds simple on paper.
Maybe a bit too simple.
Retirement planning these days is far from a simple math problem you can solve with a few fixed numbers. Many classic retirement-planning guidelines feel too inflexible in light of current economic challenges. They’re a good starting point, but you should also consider more modern alternatives, especially given market uncertainty, rising healthcare costs, and longer life expectancy. Retirement planning today needs to be more flexible than ever. AI financial planning is worth a look here, since it can offer personalized insights you can revisit and adjust as your circumstances change.
The Key Factors Shaping Your Personal Target
Moving past typical retirement planning rules of thumb, calculating your exact retirement number depends on several key factors that can greatly affect how much you will need to live comfortably in retirement.
Lifestyle and Geographic Considerations
As you consider the retirement savings you need for your lifestyle, also consider the costs associated with the area of the country where you plan to live and retire. Retirement locations can vary significantly in cost of living, and in many instances this can affect the amount of retirement savings an individual needs to maintain their standard of living. For example, a major coastal city might have vastly different housing costs, property taxes, state income taxes, and general retail prices than a quiet rural town in the Midwest, or a retirement community in a warm, sunny location such as Florida.
One factor in determining how much you need to save for retirement is your planned retirement lifestyle. Will you travel around the world or keep up your hobbies, such as playing golf? You might need 100% or more of the amount you were bringing home to your household during your working years. On the other hand, if you plan to be content with staying close to home and continue to pursue hobbies such as gardening or painting, you might only need 50-75% of your pre-retirement household income.
Healthcare and Long-Term Care Realities
Healthcare expenses will likely be one of the largest, if not the largest, unexpected expenses for most retirees. Most workers understand they have health coverage while working but may not fully appreciate the costs of health coverage in retirement, including premiums, deductibles, copays, and gaps in care that even good insurance does not cover. This includes routine care such as dental, vision, hearing aids, and prescription costs.
In addition, it’s important to plan for long-term care needs in retirement. Typically, basic government health care programs do not cover long-term care such as assisted living, home health care, and nursing home care. This requires careful consideration to save for these costs through long-term care insurance or personal savings.
Inflation and Purchasing Power
Inflation is another factor that can eat into your purchasing power over time. Even a low rate of inflation, such as 2-3%, can significantly reduce the value of a fixed income over a long period. Therefore, if your income is fixed, or you have a savings account paying a fixed interest rate, the purchasing power of that money will decline steadily over time.
This is where holding too much in cash becomes a problem. By investing in retirement accounts with growth potential, rather than just putting money in low-yielding cash accounts, you can work to preserve the value of your wealth by keeping up with inflation to ensure that your purchasing power is not eroded over time.
Debt Elimination and Major Debt Payoff Timelines
Here’s a critical factor to consider when calculating the amount you need to save for retirement: your debt. Yes, that’s right. Any debt you’re carrying at the time of retirement will increase your fixed living costs in retirement. In turn, this requires your investments to work even harder to generate cash for your living expenses. It is therefore even more important to pay off major debt obligations before retirement.
Eliminating debt has a much greater impact than most people realize. Specifically, it reduces the required cash flow to support living expenses in retirement. To illustrate, consider a person with a $300,000 retirement portfolio who has a $150,000 mortgage on their home and pays $8,333 per year in interest on that loan. In this case, we would need to add $8,333 per year to the required cash flow to support living expenses in retirement.
Sequence of Returns Risk and Market Timing
Sequence of returns risk refers to the impact the order of investment returns has on your retirement savings. Let’s say you experience negative returns in the years immediately following your retirement, while at the same time withdrawing capital to fund living expenses. In this scenario, you would likely suffer severe and long-lasting capital erosion.
Adding a liquidity reserve to account for sequence-of-returns risk could add another 25% or so to the total needed to maintain retirement goals. So, in addition to figuring out how much you need to save, you also need to decide how you will invest it. Specifically, the investment amount should allow your portfolio to reach your desired retirement goal safely.
Income Sources Beyond Your Savings
In simple terms, your personal portfolio does not have to be the sole means of supporting you in retirement. Most retirees support themselves with multiple income streams.
Government Benefits and Public Pensions
In addition to the funds that you have saved, for most workers, government benefits (e.g., Social Security) represent the largest component of their guaranteed income. The amount of the benefit(s) that an individual is entitled to depends upon a couple of key things. The first factor is the amount of earnings the individual had during their working years. Secondly, it also depends on the age at which he/she begins to receive payment(s). The earlier an individual begins to receive benefit(s), the lower the monthly amount of the benefit(s).
Employer Pensions and Annuities
This does not mean that there are no more defined-benefit pensions. Public employers, as well as some older, established companies, mainly offer these plans. Calculate the monthly disbursements from such plans and add them to guaranteed income from fixed annuities. This strategy can reduce the amount you need to generate from investments. As a result, this reduces the size of the nest egg needed for retirement.
Ongoing Work and Passive Income
You don’t have to stop working completely once you retire.
Many people in retirement transition to part-time work or another career they’re passionate about. This way, they can earn money while having fun. They also have rental properties or invest in dividend-paying stocks or bonds. These options pay them regular distributions from their invested capital.
Building an Actionable Strategy
You’ll need to keep updating your retirement needs. The process keeps updating with market fluctuations each year as you grow older.
Estimate your essential expenses to live (housing, utilities, food, health insurance, and medicine) and your discretionary expenses (travel, entertainment, hobbies). Determine the amount of guaranteed income (such as a pension or Social Security) you have. Subtract your guaranteed income from your total estimated expenses. This equation will help you to determine how much your investment portfolio needs to generate each year.
Break down your overall requirements to review one manageable component at a time. This will help you to finalize an amount to save. In turn, this will help you develop a manageable retirement savings plan that aligns with your retirement goals.
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