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Whether you are planning for early retirement or traditional retirement in your late 50s or 60s, you will need to answer two critical questions:
- How much money do I need to retire?
- How do I ensure I don’t run out of money in retirement?
How Much Money Do I Need to Retire?
The critical question that will determine how much you need to retire is how much you’ll plan on spending in retirement. Most people tend to underestimate how much money they will need in retirement.
Given how critical the question of how much we will spend in retirement is to our financial planning, we give it very little thought. For many of us, we simply assume that we will spend about the same amount of money we currently spend. Then we think, “well, the mortgage and other debts should be paid off, so I’ll probably spend even less money than I do now”.
This type of thinking can lead to woefully underfunded retirement plans.
More people are retiring with debt than ever before. If you are assuming you will retire debt-free, then you better make paying off all debt (including your mortgage) a priority in your budgeting process.
The next thing most people fail to fully account for in their retirement planning (especially those planning on early retirement) is medical expenses. The average U.S. couple retiring at 65 can expect to pay $280,000 in medical bills. If you plan on retiring in your 50s, 40s, or even 30s, you should be prepared to pay well over $300,000 in medical bills.
Putting aside the fact that people are too optimistic about their ability to retire debt-free and that they fail to account for how much their medical costs will increase in retirement. We often overlook a simple truth. The more free time we have, the more money we will spend.
Before retirement, we spend 40+ hours a week engaged in a very inexpensive activity. It’s called work.
While at work, we don’t have the opportunity to spend a lot of money. Not only do we not spend money while we are working, but for many people, their employer also covers certain living expenses that we will need to pay for ourselves in retirement. These include:
- Company cell phones
- Company cars
- Company laptops or computers
- Medical insurance
- A certain number of meals
Working more is one of the easiest ways to save money.
We spend most of our money on weekends and vacations. What happens when every day is a weekend or vacation? You’ll end up spending more money.
A Retirement Calculator That is Actually Worthwhile
There are endless numbers of retirement calculators online. Most of them have the same flaw, they let you estimate how much money you will need in retirement. We just covered why you (and I) are likely to underestimate how much money is required to fund the retirement you want.
The Wall Street Journal developed a downloadable retirement calculator that will help you answer the question, “how much money will I need in retirement?”
The brilliance of this calculator is that the only requirement is to answer questions like “how often would you like to eat at restaurants?” or “how many magazine subscriptions would you like to have?”
You don’t need to know how much these things cost; they do that for you. You only need to decide how often you would like to engage in each activity during retirement.
The calculator will tell you:
- What percentage of your income you would need during retirement?
- How much money you would need to save to fund that retirement?
The rule of 25 Times
If you are looking for a quick way to get a ballpark figure of how much you’ll need, the rule of 25 times is helpful. The 25 times rule states that you need to save 25 times your annual expenses to retire. Note that is not 25 times your annual income, but 25 times your annual spending.
If you think you’ll spend $80,000 in retirement, then you would need to save about $2,00,000 ($80,000 X 25) to fully fund your retirement.
How do I ensure I don’t run out of money in retirement?
Once you have figured out how much you will need to fund the retirement of your dreams, you’ll want to ensure you don’t outlive your money.
The simplest way to ensure you don’t run out of money in retirement is to buy an annuity. An annuity is a contract between you and an insurance company in which you make a lump sum payment (AKA your retirement savings) to the insurance company, and in exchange, they make a series of monthly payments back to you.
People use annuities to ensure they have a predictable stream of income during retirement. The problem with annuities is that they are expensive. Once you consider the commissions and fees, purchasing an annuity could cost you between 3%-5% of your retirement nest egg. We could be talking about tens of thousands of dollars.
If you were not budgeting for those types of fees, they can be a bitter pill to swallow.
The 4% Rule
For the fee-conscious DIY investor, the alternative to annuities is the 4% rule. The 4% withdrawal rate refers to how much of your retirement portfolio you liquidate in the first year of retirement. It works in direct connection with the “25 times rule”.
Using our example of needing to save $2 million to fund an $80,000 per year retirement. The 4% rule says in the first year of retirement, you withdraw $80,000 (4% of $2 million).
In the second year of retirement, you withdraw $80,000 plus inflation. Assuming inflation was 3% in year one of retirement, you could safely withdraw $82,400 in year two of retirement.
You continue in this manner for the rest of your retirement.
Be aware that the 4% rule is not foolproof. It was created during a period of higher interest rates and assumed an investment allocation of 60% stocks and 40% bonds. Given the low yield of bonds in today’s investment climate, many investors have opted to invest more heavily in stocks.
This opens you up to what is called “Sequence of returns risk”. Imagine you were about to retire in 2008. You’ve saved up your $2 million, you are all set to use the 4% rule, and then the financial crisis hits. Your $2 million is now only worth $800,000.
If you were to retire at that time, you could only safely withdraw $32,000 in your first year of retirement. That dream of $80,000 went right out the window.
Additionally, the exact opposite could happen if you saved $2 million, and right before retirement, the stock market went on a tear, and your nest egg is now worth $2.5 million. In this situation, you might be able to afford to withdraw $100,000 in your first year of retirement.
The point is you need to be flexible and adapt to market conditions when using the 4% rule.
Making sure you don’t outlive your money is the most difficult part of retirement planning. This is the reason many people are willing to pay the extremely high fees involved with annuities.
It might hurt to pay those fees, but in doing so, you are transferring that sequence of return risk from yourself onto the insurance company.
That is a decision each of us must make for ourselves.
Have you figured out “your number” that you aspire to save to pay for your retirement? How are you doing toward achieving your goal?
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About the Author
Ben Le Fort
Hi, my name is Ben. I am the founder of Making of a Millionaire. I have been obsessed with personal finance and learning how to manage money, ever since my parents declared bankruptcy and lost the family home to foreclosure in 2010.
I spent the next 10 years continuing my journey of educating myself about money. This education was both formal and informal.
On formal education, I earned a Bachelor’s and a Master’s degree in Finance & Economics.
On the informal side, I consumed every book, video, blog post, and podcast that discussed personal finance.
Education was nice, but it wasn’t until I began implementing what I learned that I began feeling more hopeful about the future.
Before long, I had paid off my first loan. Then the next. By 2015 I was debt-free. By 2016 my wife and I bought our first house. Then we started investing. We bought another house and began building real wealth.
As our wealth grew, the memories of that family bankruptcy seemed further and further in the rear-view mirror. My stress and anxiety began to melt away and I was able to sleep at night without my mind racing and problem-solving.
By 2018 I knew it was time to start sharing what I learned about managing money and Making of a Millionaire was born.
I hope you find the articles, videos, and courses created by Making of a Millionaire to be of value to you. Please feel free to reach out to me directly if you ever have feedback or questions.
You can read all of my articles on my personal site, or on Medium. If you’re interested in video-based personal finance tutorials and education, you can Subscribe to my YouTube channel or check out my in-depth personal finance course.
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