During a radio interview last week I was asked the simple but basic question of how to calculate the amount of money needed to support a prosperous retirement. This is an often asked, but more frequently misunderstood issue that needs to be clarified. How much do you really need? And once determined how do you get there and actually realize that amount of money?
The 20th century brought many things to the American people including airplanes, automobiles, cell phones and personal computers and it also brought hope for a prosperous and long retirement to millions of people. However, as the century came to a close, the concept of retirement changed for two very important reasons; a) people's life expectancy had risen from 65 years to over 80 years extending the amount of time spent in retirement and b) defined benefit pension plans had largely been replaced with defined contribution plans like 401k's. These two transitions have created the need for individuals to accept personal responsibility for their personal life and increase their knowledge of investing and money in general.
One of the absolutely critical questions is "how much do I need to put away to secure a comfortable retirement?" That simple question has so many variables it's difficult for many people to wrap their brains around it and come up with a good strong number. Just some of the variable are; how much income do you require, what is the return you can expect upon retirement, how much can you put away each pay-period, and what is a reasonable expectation for accumulating returns when considering taxes and inflation? Let's try to answer those one at a time.
First, in terms of income required, the best gauge of that is your current income. It used to be thought that you'd spend less in retirement because of things like having your house paid off. However, as more and more people choose to sell their homes and live in retirement communities instead, that may not be the case. So the minimum you should target is your current income. If you make $60,000 per year today and live as you wish, plan on making $60,000 in retirement.
Second, in terms of how much you need to secure that a good rule of thumb is that you can draw 5% out of a managed fund and still keep the fund in tact in perpetuity. That's how foundations do it for example; 4% to 5% withdrawn and the balance kept intact. Therefore, to generate a $60,000 income, you require around $1,200,000 in invested assets. That seems like a big, almost unachievable number so it leads to the third question, how do you get there?
To build that nest-egg you have to determine two things; how much can you put toward it out of your earned income and how much can you earn by investing it. The answer to that is more difficult of course but again, a very good rule of thumb is to put aside 10% of your gross income each and every pay period without exception. If this "pay yourself rule" is enforced through your lifetime, achieving that nest-egg is eminently doable. In terms of earning the required return on your money... well that's more difficult. Let's take a 40 year old with no money presently saved up so they're starting at zero! If that person earns $60,000 per year and therefore is putting $6,000 per year aside, they would have to generate a return of approximately 15% per year to achieve their $1.2mm goal by age 69.. and that's very, very difficult. So they four options; save more money each month, earn the required 15% per year which takes risk, retire after 69, or "amortize" their capital down post retirement. This fourth option assumes you use the accumulated capital to subsidize your monthly cash flow; it's a dangerous option because you're burning through your nest-egg but it may be the only option available.
So here is the bottom line; you can figure out how much you need pretty easily but to get there you need to be extremely disciplined in saving your capital not spending it, and you need to become thoroughly educated on how to invest it to make the required returns. This is YOUR job and cannot be totally offloaded. Yes you can hire a professional advisor but you must understand what they're doing with your money. You also need to grasp how incredibly important this is to teach your children and grand-children. If they understand this, they will easily be able to accumulate the money required to provide for their own retirement and they will thank you forever!