Like most people, you’ve probably wondered, “How much income will I need during my retirement years?”. You’ve also probably wondered why you never seem to run across an answer to that ubiquitous question. So how much do you need to ensure you can retire comfortably?
Why the Answer is Hard to Find
There is endless information about building a retirement nest egg and almost nothing about how big that nest egg should be. Two common reasons why the size of your nest egg is the subject of endless debate include:
- The amount is different for everyone because a “comfortable” retirement is entirely subjective
- No one can agree on how much of your nest egg you can spend each year to sustain a comfortable retirement
As an individual, the first reason is straightforward and can be answered relatively easily. On your own, or with the help of a financial advisor, you can develop an estimate with some back-of-the envelope math.
What to Consider When Determining Your Retirement
First you must decide what you consider a “comfortable” retirement. This answer is, of course, different for everyone. But with a little addition and some simple multiplication, you now have a reasonably accurate estimate of your required annual income needs in retirement.
Some basic things to consider when calculating how much you need for retirement include:
- Basic Needs: If you want a basic income to cover those needs, then you should identify your monthly necessities and multiply by 12. These items include: mortgage, groceries, insurance, utilities, car payments, and other expenses.
- Added Luxuries: If you want more luxuries, you should define the specific desired activities and estimate their approximate costs based on frequency, equipment needed, or any other related. These costs should be added to your monthly budget. Examples of these luxuries can include hobbies, a vacation home, a boat, and travel.
- Inflation: Additionally, you’ll need to consider inflation. There is plenty of information available to help establish a reasonable inflation estimate, but 3-4% is a good long-term inflation number you can use for your calculations.
The Challenges of Predicting the Future
There is more to retirement planning; however, it’s not often so easy to calculate. To decide how much you can spend each year to sustain your retirement, you need to know how long you will live in retirement and how much your investment portfolio will earn. If you retire at 65 and die at 80, you’ll need income for 15 years. What happens if you live to be 100? You don’t want to live without resources for 20 years. So, how much will your investment portfolio earn? That depends on stock market/economic conditions and the asset mix in your portfolio. You’ll also need to consider other individualized factors, such as how long you will work, social security, pensions, home equity and, of course, financial market cycles during your retirement years.
Now you can see why the “how-much” question generates endless debate. How long you will live and how much your portfolio will earn are simply unanswerable questions.
The “4% Rule”
For more than 20 years, financial professionals have been loosely guided by what is called the 4% rule. If you follow this rule, you withdraw 4% of your portfolio in the first year of retirement and then you annually withdraw that same dollar amount, adjusted for inflation, for the next 30 years. The idea is that if you follow this rule, you minimize your chances of running out of money in retirement.
While this rule is a good starting point, it has been hotly debated since it was established. Some argue that it is too conservative. Others argue that today’s low-interest environment and longer life expectancies make it too risky. Meanwhile, your financial future hangs in the balance. If the rule is too conservative, then you’ve unnecessarily constrained your retirement lifestyle. If the rule is too risky, you could run out of money just when you need it most.
The Definitive Answer to an Indefinable Problem
While the debate rages on, there is a one-word answer to this how-much question: flexibility.
And while it would be convenient to have a magic number to shoot for, that number is going to fluctuate constantly throughout your life based on a multitude of factors. So, the best answer is to maintain your flexibility—beginning when you are young by ensuring the decisions you make allow you to have more flexibility when you are in retirement. Review your retirement annually, consult with your financial advisor, ask questions, and be open to changes based on both individual and outside factors.
Amin Dabit, CFP®
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