How Much Life Insurance Do I Need?
The Role Life Insurance Plays in Your Finances The purpose of life insurance is to...
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Whether you are planning for early retirement (FIRE) or traditional retirement in your late 50’s or 60’s you will need to answer two critical questions:
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 50’s, 40’s or even 30’s 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, for many people, their employer also covers certain living expenses that we will need to pay for ourselves in retirement. These include:
Working more is one of the easiest ways to save money.
We spend most of our money on weekends and vacation. What happens when every day is a weekend or vacation? You’ll end up spending more money.
There are endless amounts 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 an online retirement calculator that will help you answer the question “how much money will I need in retirement?”
The brilliance in this calculator is that the only requirement is to answer questions like “how often you would 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. The only thing you need to decide is how often you would like to do engage in each activity during retirement.
The calculator will tell you:
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 $60,000 in retirement than you would need about $1,500,000 ($60,000 X 25) to fully fund your 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 type of fees, they can be a bitter pill to swallow.
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 $1.5 million to fund a $60,000 per year retirement. The 4% rule says in the first year of retirement you withdraw $60,000 (4% of $1.25 million).
In the second year of retirement, you withdraw $60,000 plus inflation. Assuming inflation was 3% in year one of retirement, you could safely withdraw $61,800 in year two of retirement.
You continue in this manner for the rest of your retirement.
Be aware, that 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 $1.5 million, you are all set to use the 4% rule and then the financial crisis hits. Your $1.55 million is now only worth $600,000.
If you were to retire at that time, you could only safely withdraw $24,000 in your first year of retirement. That dream of $60,000 went right out the window.
Additionally, the exact opposite could happen if you saved $1.5 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 towards achieving your goal? Let us know in the comments section below.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.