The Fundamentals of Retirement Planning
To plan for retirement, it is important to estimate how much you need in savings to comfortably cover your living expenses. This calculation involves considering several factors including your expected annual expenses, the age at which you plan to retire, your life expectancy, potential additional income sources like pensions or Social Security, and your personal risk ⓘ tolerance.
Annual Expenses
Retirees generally spend less than they did during their working years. For instance, the Bureau of Labor Statistics in 2022 reported that Americans aged 65 and older spent an average of $57,818 annually, compared to $78,691 for those under 65. However, some expenses, such as healthcare, may increase in retirement.
Social Security Benefits
Social Security benefits can be estimated by logging into the Social Security website. If you do not wish to log in, you can find a simpler calculator here. It's prudent to assume you will receive only 75%-80% of the estimated benefits due to potential future funding shortfalls.
Calculating Income From Savings
Consider you have $1 million in savings. Conventionally, you can withdraw 4% annually, adjusting this amount each year for inflation. This approach is known as the '4% rule' and suggests you can safely withdraw $40,000 in the first year. Historical data supporting this rule indicates it could sustain your finances for 30 years under certain investment conditions. However, it's important to note some limitations:
- The 4% withdrawal rate is largely based on the success of the U.S. stock market, which may not necessarily predict future performance. Historical worldwide returns suggest a safer withdrawal rate might be closer to 3.5%, as detailed in this article.
- The 4% rule does not adjust for market volatility. For example, if two investors each had $1 million and one retired just before a market crash that led to a 25% loss, they would both have $750,000. If the first investor followed the 4% rule, they would continue withdrawing $40,000, while the second, retiring post-crash, would start by withdrawing only $30,000.
Variable Percentage Withdrawal is one strategy that adjusts for market volatility. This method adjusts the withdrawal rate based on the current market value of your investments, allowing for higher withdrawals in good years and lower ones during downturns. Learn more about this approach here. If you have a higher risk tolerance, you can invest more in stocks, and will be able to withdraw a greater percentage of your savings each year. However, this will leave you more susceptible to market volatility; in a large market drop, you would need to reduce your spending by a greater amount.
An alternative strategy involves using a TIPS ladder. By investing in Treasury Inflation-Protected Securities, which adjust with inflation, you can set up bonds to mature annually, providing a predictable income stream. As of this writing, with a real interest rate of 2.21%, our calculator suggests that it's feasible to withdraw about 4.6% annually for 30 years. This method offers protection against poor market returns, but the portfolio will be depleted at the end of the period.
Note that these strategies assume the use of tax-advantaged accounts like IRAs. If your savings are in taxable accounts, you would need more in savings to compensate for taxes owed.
A Retirement Example
Suppose you plan to retire at 65. You currently spend $60,000 per year; you assume that when you retire, you will spend 80% of that, or $48,000 per year (including taxes and health expenses).
Say that according to the social security calculator, at 65, you will earn $32,000 per year. Let's assume Social Security payments could be reduced 25% due to funding issues. You would then assume earnings from social security of $32,000 * (1 - 25%) = $24,000. Therefore, your investments would need to support a shortfall of $48,000 - $24,000 = $24,000.
- Using the 4% rule, you would need $24,000 / .04 = $600,000 in retirement savings.
- Using the Variable Withdrawal method, if you retire at 65 with a 50% allocation to stocks, your withdrawal rate would be 4.8%, so you would need $24,000 / .048 = $500,000.
- Using a TIPS ladder, for 30 years of withdrawals, you would need $24,000 / .046 = $522,000. However, if you anticipate living to 100, you would need 35 years of withdrawals. In this case, the withdrawl approximate rate is 4.1%, so you would need $24,000 / .046 = $585,000.
In all cases, it would be better to have more than this number, as a buffer for unexpected events.
Conclusion
Retirement planning involves uncertainties, especially regarding future investment returns and expenses. However, these strategies provide a structured way to think about your savings needs. We recommend that you use conservative estimates and plan for flexibility.