The idea of retirement is scary to some because of the uncertainty and unknown associated with a timeframe so far in the future. When you are young, many can’t even fathom what retirement means and don’t even think about planning for it. The biggest long term financial goal that most people have is saving enough to retire.
Phases of Your Financial Life
Retirement is an obscure concept. You will reach an age where you no longer work and must live off your investments (and social security, if it still exists). It’s generally a good idea to be aware of the phases of your financial life:
Earning Phase – Most people enter the workforce and start earning a steady paycheck. Many are stuck paying off large student loans.
Accumulation phase: Typically ages 30s – 60; This phase includes savings and investing for growth. Savings is not enough and you will need to take on additional risks by investing in investments with higher rates of return such as stocks. If you just put money in a bank account, you’ll actually be losing money in the long term as inflation eats away at your purchasing power. You should invest and automating contributions is key to success. During this phase, you might also have short term goals, such as buying a house, planning a wedding, or buying a car.
Distribution Phase aka Retirement: Typically starts at 60-65 years old. This phase involves withdrawing from your investments to pay your living expenses. With life expectancy ranging from 85-90+, you should plan for 25-30+ years of distribution.
There are lots of factors and considerations along the way such as having children, job security, social, economic, and political changes. These are just some examples that can disrupt even the best laid plans.
Unlike what financial institutions and media would have you think, planning for retirement should not be scary. Let’s break it down further using math.
So the #1 question that people ask about retirement:
How much money do you need to retire?
Other common questions include:
When can I retire?
I saved $X amount of dollars. Is this enough to retire?
Answer to all of the above: It depends.
Your retirement needs should be tailored to your situation. Everyone and every family is different. There is no one-size-fits-all solution. Let’s break down the approach to answering the question and work backwards to understand how much money you’ll when you retire.
A person spends most of his/her life earning and contributing to 401Ks, Thrift Plans, IRAs, brokerage, and other accounts to build a “golden goose”. You can look at this “golden goose” as your total investment.
How much money will you spend in retirement?
Essentially, you should think about what amount of money you’ll need to survive when you are retired. Financial advisors sometimes follow the 80 percent rule where retirement expenses are 80% of pre-retirement income. This is just a rule of thumb.
In another post, I talked about the importance of a budget. A budget is a helpful tool to figure out how much money you’ll need to cover your expenses.
Let’s consider a crazy concept – how much money would you need to retire today. Yes, not waiting until you’re 65 years old.
Breaking down your retirement number – using basic math
Let’s say your annual expenses are roughly $35,000 a year and are pretty steady over the past couple years.
Another rule of thumb that financial advisors sometimes use is the “4% rule”. The 4% rule means you should only withdraw 4% from your “golden goose” or investment value each year.
Let’s say your “golden goose” is fully invested in stocks that have an average return of 10%.
Subtract inflation which typically averages 2-3%.
Now, remove the 4% withdrawal.
10%-3% inflation – 4% withdrawal = 3%
Even accounting for inflation and withdrawing some money each year, your total “golden goose” is still growing at a rate of 3% a year. Even with withdrawing money each year, your “golden goose” continues to grow and lay the golden egg.
So, you have $35K in annual expenses, and you withdraw 4% from your “golden goose”/investments. How large should your “golden goose” be?
Here’s the math:
$35,000/.04 withdrawal = $875,000
Some financial advisors might suggest that you be more conservative and withdraw only 3% of the total value.
In that case, let’s tweak the numbers:
$35,000/.03 withdrawal = $1,166,667
So to have $35,000 a year to pay for your expenses by only withdrawing 3%, you’ll need a nest egg of $1.17M.
The above numbers are for illustrative purposes. Your numbers will change depending on your lifestyle, charitable giving, and what you’d like to leave behind for your children as an inheritance. If you are concerned about expenses in retirement, build additional cushion in your annual expense target.
You now have a clear way to set a retirement goal.
Reaching your retirement or investment goal using a spreadsheet model
As an engineer who worked in financial services, I created an Excel model (Click Here to Download)to help you map out what your investment value could look like over time. This is a simplified model that doesn’t include some factors such as Social Security benefits but I wanted to share the concept and how it can help reach your retirement goals.
The model maps out a person’s life from age 16 through 75. The United States is a broad market with varying income levels. I used data from a current US population survey to show annual income breakdowns for different segments of the US. These income levels are divided into the following:
- 25% percentile
- Median income
- Average income
- 75% percentile
- 90% percentile
I’ve included each of the income levels as an indicator of what is possible for all ranges. Income levels matter. The greater your income, the more money you can save and invest.
The key variables that drive the model include:
- Income Level
- Use the level that largely maps to your situation
- Investment return
- Assume an investment return percent. A portfolio that is 100% stocks would average 10% nominal return. If you want to account for inflation, subtract 2.5-3%. Your total return would be 7-7.5%.
- When you start investing.
- Some people start late while others start early. Everyone’s circumstances are different. You can see the significant impact when you start saving early.
- Savings Rate
- Your savings rate is the item that you have the most control over and is a critical factor in the model. The general rule of thumb is to save at least 15% of your income. Play around with this field to see the impact of increasing your savings rate.
Let’s go through a few examples:
If you are an average US salary and start saving at age 24 (assuming a 7% annual investment rate of return), by the time you’re 65 years old, you’ll have roughly $2.3M.
If you retire at 65, and take out 3% a year, you’ll have $69k in income to survive. Not bad.
The various levers matter. Let’s look what happens if you start saving and investing at a later age.
If you keep all factors the same but start saving 15% of your salary starting at age 30 (instead of age 24 from the previous example), by the time you’re 65, you’ll have roughly $1.6M saved.
If you take out 3% of $1.6M is $49K.
Note that these examples don’t account for taxes when you withdraw from your investments.
Another key factor to wealth: Your Savings Rate
What happens if you increase your savings rate or what you contribute to your investments.
Increasing your savings rate might mean you need to reduce your current expenses. If you don’t live beyond your means and are wise with your money, you can save a significant portion of your income.
As a hypothetical, what happens when your increase your contribution rate from 15% to 50% of your salary going forward from age 24?
By the time you’re 65 years old, you’ll have $7.4M. That’s the power of compounding!
Would you really need that much? With proper planning, you can retire much earlier. If you like working, you can always donate to charity or leave a sizeable inheritance to your children and grandchildren.
The Average Retirement Savings in the US
Most people in the US don’t save enough for retirement.
According to the 2019 Survey of Consumer Finances (SCF) conducted by the Federal Reserve, the average retirement savings by age in the US is as follows:
• Ages 18-24: $4,745.25
• Ages 25-29: $9,408.51
• Ages 30-34: $21,731.92
• Ages 35-39: $48,710.27
• Ages 40-44: $101,899.22
• Ages 45-49: $148,950.14
• Ages 50-54: $146,068.38
• Ages 55-59: $223,493.56
• Ages 60-64: $221,451.67
• Ages 65-69: $206,819.35
Most people do not have a plan so these figures seem low compared to what’s possible if you are informed and practice good financial habits.
If you’re 65-69 years old, 4% withdrawal from an average $206,819.35 retirement savings = $8,272.78 per year. This is not enough to survive so you’ll be dependent on Social Security or you’ll need to continue to work until you are unable to do so.
How can I retire early?
There is actually a whole Financial Independence, Retire Early (FIRE) community of people who aggressively save and invest as much money as they can and retire at a young age. Engineers who are analytical have crunched the numbers and figured out how to stop working or significantly reduce their hours to spend time with their families while they are younger and healthier.
If you do a quick google search, you’ll find an array of different FIRE calculators where you can figure out how to achieve financial independence. Here’s an example of one calculator from Playing With Fire.
There are many blogs about this topic and many bloggers write about their experiences and even post income reports where they are transparent about their income and expenses.
Here’s a few examples:
When I learned about the Financial Independence, Retire Early (FIRE) movement, I thought it was a fascinating concept and was instantly hooked.
We are all programmed to work hard, go to college, get a job, and then save for retirement but the retirement figure may seem like a mystery. People continue to work until they reach retirement or until they aren’t able to work anymore. I’ve seen many people spend their entire lives working to save for retirement and some die before they enjoy the fruits of their labor. Hopefully, you’ll be able to better plan for the future and take control of your financial life.
Summary:
Know the different phases of your financial life include earnings, accumulation and distribution phases.
How much you need to retire depends on your individual circumstances. But you can apply basic mathematical principles to estimate how much you need to save for retirement based on your spending.
Once you have a general retirement goal, you can use a basic spreadsheet model to help you to achieve that retirement goal based on income, investment return, when you start saving, and savings rate.
