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Determining how much you need to retire
Ever wondered if you have enough saved up to retire? Where do you start, and how do you calculate what you need? This question is prevalent, and when I was working in an advisory capacity, clients asked me this daily.
Time and time again, Americans are told the mantra that they need $1,000,000 to retire. Is this true?
No, it is not. Throw this myth out the window, as you need whatever it will cost to support your unique spending habits in retirement, not your neighbors. For some people, this means $400,000; for others, it means $4,000,000. So next time you hear in the news that you need $1,000,000 to retire, roll your eyes.
The amount you need to retire is the sum of all day-to-day expenses, plus what you want to budget for discretionary spending. Once you have annualized this figure, you know your yearly income needs. Once you know your needs, we must estimate your lifespan to calculate the savings number needed. Generally, most retirement planners prefer scenarios where you never fully deplete your savings. Hence, this is why the 4% rule is popular amongst professionals and amateurs alike in finance.
For those unfamiliar, the 4% rule states that if you withdrawal only 4% of your invested portfolio annually, you will never run out of money.
I agree with most retirement planners, as there are too many unknowns to try to spend your last penny the moment you die. As perfect as this would be for some, it is not feasible. Thus, we are left with the question, how much is enough?
Well, using your annual expenses, lifespan, and current savings, we can evaluate if your current savings can support your lifestyle using math. Bust out your calculator!
Annual Expenses/0.04 = Retirement Savings Needed
Now, we need to factor in various market scenarios to evaluate the likelihood of success. So, start…
Just kidding, I am not going to make you determine this on your own. Instead, Vanguard makes an excellent tool for those just beginning the retirement planning journey.
Shout out to My Money Blog for bringing this tool to my attention and inspiring today’s post! Before this tool, I exclusively used the Fidelity Investments Retirement Analysis tool. Now, I use both, and while Fidelity’s tool is excellent, it requires more inputs and thus is offputting for some.
No tool can guarantee success, but the Vanguard & Fidelity tools can help evaluate the likelihood of retiring successfully. If the scenarios come back poorly, then we know you haven’t saved enough. If the scenarios come back rosy, then you are likely in good shape. Remember, though, neither you nor I can predict every future scenario, and these are just well-placed estimates.
Now, for me, success means not running out of money or have to change my ideal retirement dramatically.
The tool we will use
For today, I suggest starting with the Vanguard tool, as it does not require creating a username/password. Then, if you want to take a deeper dive, consider making a profile with Fidelity to use their tool (or use it as a guest). You are not required to open an account to use Fidelity’s planning tools and can use them as a guest free for 30 days. Full disclosure: I used to work for Fidelity Investments, but I no longer do. I have no financial or business relationship with Fidelity; I just like their tool.
Now, to use the Vanguard tool, all you need to know are three variables we previously covered: Your amount saved, yearly expenses, & estimated retirement span. Enter these in, and then Vanguard will estimate the rest!
For those who receive social security, deduct your estimated or actual payments from your expenses, as these are dollars your retirement portfolio will not need to produce. If you have a pension or other passive income, you can deduct it out of your costs too.
[Link to Vanguard tool]
[Link to Fidelity tool]
So let’s use Jane as an example:
Jane has saved $850,000 for retirement and is 60 years old. Jane has decided that she is likely to live until age 90, and she just retired. Congratulations Jane!
Since Jane is 60 and plans to live until 90, she needs to prepare for 30 years of retirement when using these tools.
Now Jane has estimated on average that she will spend around $52,400 a year. Of this amount needed, her social security pays $1,200 a month. Thus, social security covers $14,400 of her yearly expenses, leaving her with $38,000 that her savings must draw from her savings.
So Jane enters her numbers of $850,000 saved, $38,000 in expenses, and a 30-year lifespan. Vanguard crunches the numbers, and voila! Jane’s likelihood of retiring at her desired lifestyle without adjusting her plans is 85%.
Thus, Jane can conclude that she has a high likelihood of success but that in 15% of predictable scenarios, she will have to modify her plans.
The analysis that Vanguard did for Jane is called a Monte Carlo Analysis (MCA). The basics you should know about the MCA are that 100,000 different scenarios are run. Your likelihood of success, 85% in Janes case, shows the number of the outcomes where the money never runs out. Even if you receive a 100% success rate, there is no guarantee as you may have a life event that forever changes your income needs. Thus, all we can do is plan our best and adjust when things change.
Now in the 15% of scenarios where Jane runs out of money, she will either need to modify her living expenses, invest more aggressively, or risk running out of money.
However, as indicated in 85% of scenarios, she will be okay. For Jane, 85% is a palatable success rate, but that may or may not be for you. Determine how certain you want to be and use this tool as a gauge! Then, if you desire a deeper dive, give Fidelity’s tool a try.
[Link to Vanguard tool]
[Link to Fidelity tool]
For those who go on to using Fidelity’s tool, Fidelity uses a 150 point scale. Think of your score as a $1 bill: For amounts under 100, this means you will have $0.xx towards every dollar needed in retirement. However, for scores above 100, this means you will have $1.xx for every dollar required in retirement.
So, now that you know how to estimate your retirement needs, what is your retirement number? Is it $1,000,000, or is it something else? Let me know in the comments below. Suppose you ever want to check your progress towards financial freedom and not near a computer. In that case, the easiest and most common method is to take your current retirement savings and multiply the amount by 4%. The outcome produced is the generally accepted safe withdrawal rate of 4% of your portfolio, which in theory, should last forever when invested in a well-diversified portfolio.
In the future, I will do a more detailed post on the 4% rule, but for now, use these tools as a guide. Thanks for reading today’s post, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time
Great post, didn’t know it was called a Monte Carlo analysis!
Thanks, Gen Y Money! I’m glad you found this post of value.