This is the year you figure out your number. Right? It’s not as difficult as it may seem. Yet by some estimates fewer than half of Americans have ever tried to divine how much money they will need in the bank in order to retire comfortably.
That’s crazy. The public and private pension systems are cracked, and in fiscal cliff negotiations even Democrats have seemed willing to curb future inflation-based increases to Social Security benefits. Your retirement is your business alone. You should try to understand what you will need.
Now is a good time to work it out. Americans are beginning to feel more confident about the economy even though 4th quarter growth was disappointing after solid growth in the 3rd quarter. In general, they have also gotten more realistic about future investment returns in this low-rate environment, and many are more committed than ever to tending to their financial future. A record 46% of adults made New Year financial resolutions, according to an annual Fidelity Investments survey. A record 62% say they stuck to their New Year financial resolutions last year.
In general, individuals say they want to save more, spend less, and pay off debt. All good. But while setting specific near-term goals in these areas, why not take a moment to consider the big prize that, consciously or not, each of these measures is designed to facilitate: hitting your number.
“It’s important to know your nut,” says Lule Demmissie, managing director of retirement at TD Ameritrade. Obsessing over a big number can be paralyzing, she concedes. “So just think of it as a starting point,” she adds. “What’s important is that you make progress toward it every year.”
Calculating a Comfortable Retirement
To help guide you to your number, financial firms have devised income and actuarial models that come up with a target multiple of your final year’s salary. Benefits consultant Aon Hewitt says that by age 65 an average full-career worker needs to have banked 11 times annual pay. That means a household earning $75,000 a year would need to have saved $825,000. Work to age 67 and the multiple drops to 9.4 ($705,000); retire at age 62 and the multiple rises to 13.5 ($1 million).
The fund company T. Rowe Price advises a multiple of 12 times final pay, while Fidelity calculates that a multiple of eight times pay will do the trick. All the firms use slightly different assumptions. But you can see that they are in the same ballpark and, more importantly, that it’s a big park.
Looking at it another way, BTN Research estimates that, assuming 5% average annual investment returns, for every $1,000 of monthly income you want over a 30-year retirement, you need $269,000 in the bank. Let’s consider that same household making $75,000 a year. To replace the commonly recommended 80% of income in retirement — or $60,000 in this case — the household would need $5,000 a month. In this calculation, this household’s number is $1.35 million, or 18 times final pay. A higher investment return would bring the numbers down.
Finally, there is the approach that Dallas Salisbury, president of the Employee Benefit Research Institute offers: You need 33 times what you expect to spend in your first year of retirement—after subtracting Social Security benefits. Let’s take that same household, which spends every penny of its $60,000 income in retirement. Say this household collects $20,000 a year in Social Security. That leaves it spending $40,000 from other sources. So this household still needs a nest egg of $1.32 million, or just shy of 18 times final pay.
Don’t be discouraged. These are just estimates. A household with two good traditional pensions plus Social Security, and zero savings, might be in fine shape while a household with $1 million in the bank and no guaranteed lifetime income ends up struggling. That’s why your spending–not your savings–may be the most important part of the equation.
Basing your number on final pay has another flaw. What if you are frugal and live on far less than you earn? The household that earns $75,000 a year but saves 20% and thus spends only $60,000 need not squirrel away as much as a household earning $60,000 a year but which through credit spends $75,000. The latter household, by the way, is headed for real trouble — and, sadly, this situation is not uncommon.
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What you spend determines your nest egg needs. “In retirement, the key is to make sure your burn is less than your earn,” says John Sweeney, executive vice president of planning and advisory services at Fidelity. Everyone’s situation is different, which is why you need to think through your own case.
An array of online calculators can help you sort this out. Some key considerations:
- Life expectancy The Society of Actuaries estimates that for a married 65-year-old couple, there is a 45% chance of one person reaching 90 and a 20% chance one will reach 95. Plan for a long life.
- Medical costs EBRI estimates that a 65-year-old couple in 2019 that does not have any employer-provided health benefits will need $450,000 to have a 50% chance of funding health care expenses not covered by Medicare. Even with employer benefits, there is a 50% chance that out-of-pocket expenses will reach $268,000. Plan for this big expense.
- Inflation Over 30 years, expect inflation to cut your spending power in half. You would need nearly $12,000 today to match the spending power of $5,000 in 1982.
- Investment style You may never reach your number if you hide from stocks. Bond yields and short-term interest rates are so low that, adjusted for inflation, you may get little or no growth for years.
- Savings rate A good rule of thumb is saving 15% of income each year throughout your working life. That puts you on track to replace about 85% of your final year’s salary for 30 years of retirement without worrying about some gigantic number. If you have not been saving at that rate, you may need to adjust your savings plan or your retirement expectations.
Most planners will tell you that there is no magic number, and they are right. Life has a way of throwing curveballs when you least expect them and there are so many unknowables like how long you will live and what the markets will do that you need to reassess your plan often as you approach retirement—while you still have time to change your savings patterns and choose to work longer if you must.
So what can you do now?
Start with a list of all your monthly expenses. Go through it looking for areas that you can or will reduce in retirement. Now consider any new expenses like escalating health care costs and travel and hobbies. Identify which of these is a fixed cost and which is discretionary. You’ll need a big enough number to secure an income stream that covers all fixed costs. This is your base number, the lowest one that you should consider acceptable.
You’ll need additional funds set aside for contingencies like a run of unusually poor investment results or unusually high inflation, and for emergencies like a new furnace or roof. On top of that you’ll need a pool to support your discretionary expenses.
Social Security and a traditional pension may cover your base needs and possibly leave you prepared for contingencies, too. If so, you’re number will be based entirely on discretionary spending including what you plan to leave to heirs, an enviable financial situation. To cover fixed costs, you may need to purchase an immediate fixed annuity if other lifetime income sources are insufficient. Another option is to draw down your portfolio by no more than 4% a year, a strategy that should give you steady income for 30 years. Your number is your business. You might as well know what it is.