One of the most crucial aspects of retirement planning centers around how much of an accumulated nest egg you will need to comfortably provide income during retirement. Many savers put back a certain percentage of their income or dollar amount specifically for retirement without truly assessing how much they will need to meet their spending goals and lifestyle desires in their golden years.
Most people associate “retirement” with daily golf outings, travel, and having the time to spend with family. For many, the goal in retirement is to have the complete financial freedom to pursue passions and interests without relying on traditional employment. While certain expenses may be lower since retirees are typically not supporting children financially and buying homes or vehicles, depending on the lifestyle chosen, retirees may wish to have plenty of money for fun traveling and exploring and pursuing other hobbies and interests.
There are two main aspects to consider when it comes to determining when retirement from traditional employment can become feasible.
What’s your number?
The first and most crucial is your “financial freedom number” which is the balance of money that will be necessary to generate enough income to sustain your basic necessities along with any desired lifestyle expenses during your retirement years. The second aspect is your overall time horizon – how long will you be saving for retirement and the length of retirement.
A good basis to assess your personal financial freedom number is your current income. On your current income, if your mortgage has been paid in full along with any other debts, children are self-sufficient and no longer require your financial assistance, and the other costs you will not have in retirement are removed from your monthly expenses, would you have enough left over to sustain your basic spending needs and allow room to pursue your ideal lifestyle?
Perhaps you make $50,000 per year and you have determined this amount will allow for a perfectly content lifestyle in retirement. On the other hand, maybe your current income is $50,000, but you are really wanting to retire and withdraw $100,000 per year from your investments in order to support a higher quality lifestyle.
Either scenario is perfectly logical and possible to achieve with diligent portfolio planning. As an example, we will discuss my own retirement goals.
Even though I am only in my mid-20s, my personal goal is to have a properly diversified portfolio that will generate around $200,000 per year in today’s dollars (which is more than double my annual salary) once I turn 60.
While $200,000 is quite a large sum of money, because of inflation that has
historically averaged around 2% per year, in real dollar terms, $200,000 in
over 30 years when I near age 60 will really only be equivalent to the half the
lifestyle or that $100,000 would buy. In order to have the buying power that
$200,000 would provide today, my goal for retirement income would really be
around $400,000 due to inflation.
Now that I have assessed the balance needed to generate a future lifestyle that $200,000 would buy today, the next step is to determine the balance that would need to be invested in order to produce $400,000 per year for the rest of my life.
The S&P 500 which is the benchmark for the stock market as a whole has historically returned 10% per year on average. Because this is just an average rate of return over the past decades, there have been periods where the market plummeted nearly 40% such as in 2008. While the market was extremely volatile due to the financial crisis, in the following year, the market returned more than 20%. The main concern in retirement is to be able to ride out market lows in order to not have to sell your investments when the market is down while relying on other income for consumption.
While the majority of my liquid assets will still be invested aggressively, in retirement, I do not plan to have 100% of my investments in the stock market as they will be spread across a portfolio of primarily stock investments, coupled with shorter duration bonds as well as cash of about 6 months of expenses to offer a bit of a buffer against market volatility and allow me to stay invested if the market dips 10% in a given month or year.
Even though the market has historically returned 10% and my personal portfolio has averaged around 12% due to more growth-oriented stock allocation, to determine the balance I would need in retirement, I have assessed a safe withdrawal rate of 6% in order to mitigate the risks of inflation and account for a slightly less aggressive allocation. Typically, financial planners will offer a similar, albeit conservative withdrawal rate of 4% in order to preserve principle.
Based on my assumption of a 6% withdrawal rate, I would need a portfolio of a little over $6.5 million in my Roth IRA and Roth 401(k) to safely withdraw $400,000 of the portfolio per year tax-free without touching principal.
Now that I have determined the balance needed in retirement that would safely produce $400,000 in income without reducing principle, the next step is to determine how much I would need to contribute in order to achieve a balance of $6.5 million by the time I am 60 years old.
While I do currently have a substantial sum socked away for retirement, let’s assume I am starting fresh with no retirement savings. Based on the historical market rate of return of 10% per year, I would need to contribute $24,000 per year or $2,000 per month until I reach age 60 in order to have a $6.5 million portfolio in retirement based on my time horizon.
Because of other expenses that I currently have including housing, vehicles, and taxes, saving $2,000 per month is possible but would not allow for any room in my budget to enjoy life. However, as I am still very early in my career, my salary will steadily rise with pay increases and promotions or job changes which will allow for greater savings towards retirement along with assistance from employer matches in my Roth 401(k). Additionally, my monthly cash flow in retirement excludes any Social Security benefits that will hopefully still be providing an annuity of income.
The overall key to determining how much you will need in retirement is to estimate expenses you would have in retirement in today’s dollars and then adjust the expenses for inflation. As a basis for estimating expenses, inflation of 2% will cause the cost of living to double every 36 years. Therefore, if you have around 40 years until retirement, expect your current estimated expenses to cost twice as much when you retire. If you have 15 years or so until retirement, your monthly expenses will probably increase by more than 50%.
Properly estimating your expenses will allow you to begin planning for how much you will need to save to have your dream retirement.
Time in Retirement
The second primary contributor for determining how much you will need in retirement is the length of a given retirement. With life expectancies ever increasing with the advancements in healthcare, enduring a 30 to 40-year retirement may be a real possibility and hurdle to consider.
Withdrawing 4%-6% on a portfolio generating 8% or more should allow for an indefinite retirement as the principle will not be consumed by spending. However, as most retirees’ portfolio and savings will not be large enough to sustain a 40-year retirement which could come with significant healthcare costs as we age, other scenarios and options must be considered to determine how much money is needed to comfortably retire.
If you do wish to retire “early” at 60 or younger and do not have a substantial portfolio that will sustain you and your family indefinitely, considering a part-time job or starting your own business that coincides with your passion after retiring from your 9-5 job may be a lucrative way to ensure you and your family have the income that may be needed when you cannot work due to health reasons or old age. By retiring earlier in life, you will hopefully still have the energy and health to travel while also having the ability to earn money from your encore career centered around your interests or passion.
By continuing to earn any income in formal retirement during your encore career, you will be allowing your portfolio to compound as less is withdrawn. Additionally, if the market were to endure a correction, you will have the ability to either invest more or ride out an economic downturn while also keeping your professional skills sharpened should you need to return to work full-time.
Besides the monetary benefits of working in an area that you find interesting in retirement, there are also substantial social benefits for retirees working part-time. Developing a community of co-workers and abiding by a normal schedule in conjunction with the flexibility of being retired could be a great lifestyle to consider as many retirees become bored or lose their purpose once retiring.
If you do not wish to work for part of your retirement, you could also reduce the stress on your retirement portfolio by simply working a bit longer and reducing the time horizon that your investments will need to sustain your lifestyle. If you are in a career that you love or that offers the flexibility you desire, continuing to work in your established field could allow you to continue building wealth and offering a fulfilling lifestyle. When the time ultimately comes to retire, hopefully, the added income-earning years, investing, and market returns, coupled with a shorter duration in retirement will allow your investments to sustain a successful retirement.
Determining a desired lifestyle in retirement is totally driven by personal preference. Whether you desire to retire early and work part time or are perfectly content working past the early retirement age in your current career, assessing your expenses in retirement while considering the impacts of inflation on your nest egg is essential. As life expectancies continue to rise, understanding and planning for a lengthy duration of retirement should also be considered. No matter your age, you should carefully consider your personal spending needs in retirement and steps necessary to achieve a portfolio of investments that will replace the income from working full-time.