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How Much Money Do You Need to Retire?
Are you trying to estimate that epic number which equates to financial independence for life?
How much money you need to retire can be estimated based 5 important factors: your expenses, income sources, net worth, expected investment returns, and inflation.
In this post, I’ll address each of these factors, based on what I’ve learned over the past 20 years since my husband stumbled into an early retirement and almost 40 years of personally investing myself.
Then I’ll provide a link to a calculator where you can enter the numbers you’ve assembled from these 5 factors. There are many considerations beyond calculators that will affect the amount of money you need to retire, however, as addressed below.
As always in my posts, I’ll point out some potential pitfalls with commonly accepted finance and investing methods, most of which I learned the hard way.
Investing and net worth seem exciting, while expenses seem boring. Yet the cost of your lifestyle is the foundation for how much money you’ll need to retire. There’s just no way around this.
The great thing is that you are in control of your spending, unlike some of the other factors that affect the amount you need to retire, such as inflation.
Realizing that your spending is based on choices and priorities is empowering. It’s a great place to start.
Most people can reduce their lifestyle expenses with a little tracking. Many people like to use software for this.
If you know how much money you spend every month, you can skip to the Rule of 25 header below.
If you aren’t certain how much you spend every month, here is my process. You can use it, or any number of software applications. My process takes about half an hour once a month, and about an hour once a year making it well worth the effort for the financial clarity gained.
Create a list of all places that money leaves your accounts. I think of these as holes from which money flows out.
For us, this includes credit cards, and bank accounts with a few random checks and auto bill pay. You may use PayPal or other platforms to pay expenses. What I have learned is that the fewer holes that money flows out, the better.
I don’t track cash since I use credit cards mostly because I like to earn miles for a planned super trip. I hate credit card interest, so we avoid it except on the very rare occasion when we slip up. (We are far from perfect, so anyone can do this.)
Download the transaction by month into a spreadsheet. I use Excel or a CSV file that I can save as an Excel file but you can use whatever you like.
Copy, paste and then total your expenses all on one spreadsheet. All this takes less about half an hour.
Just for fun, if you want you can analyze further. If you do this, you can sort by vendor, and then group 2 or 3 major expenses, such as groceries or housing. (I love to see how much we spend on groceries since we have multiple grocery shoppers buying at different stores.)
I highlight the expenses that are errors, overlooked or no longer needed. I like to call or email about them right then.
Put the total monthly expenses into an annual spreadsheet, which you can divide by 12 to get a monthly expense amount.
Extraordinary Expense Tracking
While this process seems fail proof to adequately track expenses, I discovered this missing piece a few years ago and began disarming it: extraordinary expenses and once a year expenses have to be covered from income, too, or come out of your investment accounts. So, these stealthy little deviants go onto a spreadsheet once a year in about half an hour annually.
Then this total gets added to the monthly expense amount above. This gives you the real cost of your lifestyle.
First, I have found that forgotten expenses are the worst, but when you expect them, you can plan around them. You can make a conscious decision about how you’ll cover them, and if they are worth the cost if you have to take money from your investment accounts.
Second, you can change your lifestyle and reduce the expenses when you know what they are.
Property taxes, for example, are a big one for most people. But the amount is based on your home value, so you can change it if you choose. Income taxes, home repairs, car repairs and tax preparation fees can be other random big expenses.
If you do this process, you’ll know how much your current lifestyle expenses really are. This sense of order and being proactive will bring an immediate sense of accomplishment and peace to your financial life.
Decide How You Want to Live in Retirement
The next step is to decide if you want to live on less in retirement, as traditional retirement planning suggests. For simplicity, let’s say you live on $10,000 a month now. Without work related expenses, you’re happy to plan on income of $9,000 a month.
Living on less doesn’t sound too good to me. But shifting your thinking to priorities, conscious decisions, and having funds for life without fear can feel pretty great.
Rule of 25 Retirement
When estimating how much money you need to retire, you can stop right here if you want and take a shortcut with the Rule of 25.
This rule simply takes your annual expenses and multiplies them by 25 to get the amount of money you need to retire. This formula is very popular among the FIRE (Financial Independence Retire Early) advocates, most of whom are under 45. (I cannot find the name of the actual creator of the 25x retirement rule to give credit.)
With the Rule of 25, if you spend $100,000 a year, you’ll need $2.5 million to retire, for example.
I don’t use this as a hard and fast rule because it is based on an annual long term return from stocks of 7%. This leaves you with a real return of 4% after inflation, as explained more below. I think a 7% return expectation on a diversified portfolio can be overly optimistic during certain stock market cycles.
Jack Bogle Stock Market Return Prediction
If you are using the Rule of 25, consider this. Vanguard founder and legendary investor Jack Bogle predicted at his annual meeting in late 2018 that stock market returns over the next decade will be 4% annually, and bonds annual returns will be 3.5%.
Bogle explained that with inflation at only 2% and an investment portfolio divided equally between stocks and bonds, an expected after inflation annualized return might be 1.75% before taking out fees. Just think, with inflation at the 3% average and investment fees of 1%, your returns could be negative.1.
My logic is also that, based on history, a decade or two of high stock market returns is typically followed by a decade of low stock market returns.
For this reason, I like to at least consider the stock market returns of the past decade for a guide to what the next decade might hold instead of assuming the annual return over 10 to 20 years (years which many people don’t have before retirement).
It appears that Bogle is doing the same, since as of late 2018 the US stock market had been in a bull market for almost 10 years.
Considering this, the Rule of 25 would be more reliable after a decade of poor stock market returns.
Note that this rule also does not consider other income sources, such as social security, or alternative income streams such as real estate rentals. You could, however, use it with an awareness of these limitations and being aware that the return expectations are high.
On the other hand, after a bear market, when everyone hates stocks, the 7% annual returns used in the Rule of 25 may prove to be too conservative. This is why I like to consider the recent stock market trends before committing to an expected return from which I plan to live.
While there is no way to know for sure exactly how stocks and bonds will perform in the future, you can refine your estimate with just a little more information about investment performance over the past decade.
The next step to discern how much money you need to retire is to list and total all your income sources, such as social security or pension. Deduct your expenses from this amount. The balance is what you’ll need to cover from other income. We’ll call this your retirement income gap. The options are many to cover this gap. Here are some ideas.
You can withdraw from your retirement account. This is the most common method to pay expenses in retirement. Click here to read my post about the standard 4% retirement withdrawal strategy.
You can invest in traditional income producing assets that generate enough income to cover all or part of this expense gap. This solution could range from high dividend stocks, bonds or selling covered calls on your stocks.
MLP’s and REIT’s are other slightly alternative yet traditional income generating investments.
You could work part time.
You could start a small business related to something you’ve always enjoyed.
You could do some consulting work.
The real question is what do you want to do? Doing what you want vs doing what you feel like you have to do generally leads to much better results.
You can’t really decide how much money you need to retire until you make some decisions about what else, if anything, you want to do in retirement that is income related. We found it interesting and enjoyable to develop alternative income streams, especially online businesses, but you may not feel the same, and we did get started slowly in my mid 40’s.
Next, you’ll want to consider your net worth.
One reason I like to consider net worth vs just investment account size (in retirement calculators) is that you may have a lot of your net worth in your home. Many people over 50 do. Assuming you’re willing to downsize your home should the need arise, you’ll need less in your investment accounts.
For example, if your net worth including your home is $2,000,000 and your investment accounts are worth $1,000,000, the amount of money you need to retire will be quite different if you consider your net worth vs your investment accounts. After downsizing, for example, you could easily have another $500,000 or more to add to your investment accounts. This will have a significant impact on how much money you need to retire.
Retirement calculators, however, can only consider investment accounts. This is yet another variable that can make one size fits all retirement planning ineffective.
Living Off Investments Vs Living on Investments
Let’s assume that you want to live only off investments, the typical retirement plan. At this point, you’re faced with the decision of whether to live off income from investments only or dip into your investment capital. Your investment capital consists of both your capital gains and the amount of money you saved and put into your investment account.
If you have plenty of savings, this can be an easy decision.
If you have, for example, if you have $1,500,000 earning 5% investment income from stock dividends, it will make $75,000 income a year before taxes. If you can live on this $75,000 a year (along with any other income sources), you can live off your investment income.
If you have $500,000 earning 5% in dividend income, the income will be only $25,000 a year. You would need to withdraw capital from your account if you needed more than $25,000 a year to live (not considering other income sources.) In this case, you’d be living on your investments.
Is it bad to spend your investment capital?
If you have $3,000,000 in liquid assets, little or no debt, don’t care about leaving an inheritance and it costs you $100,000 a year to live, it probably doesn’t matter if you’re spending your capital.
On the other hand, if you have $1,000,000 in liquid investments, a mortgage, and it costs you $100,000 to live, you’ll probably want to think twice about spending your capital. You’ll need that capital to generate more capital gains and income.
Ideally, you can find the sweet spot in between being afraid to enjoy your money without worry and not spending too much, while expecting the best but planning for the worst.
This simple math is very telling.
Expected Investment Returns
Expected investment returns are just that. They are expectations, and not a sure thing, creating probably the biggest layer of unreliability in deciding how much money you need to retire.
The longer the time frame, the more reliable the numbers are for expected investment return. The problem is that most people focusing on how much money they need to retire are usually in midlife or beyond.
Plus, it is worth repeating that following long bull markets when everyone has high expected returns from stocks, the investment returns are most likely to be sub par in subsequent years.
Consider the two horrific bear stock markets in the 2000s decade, for example. Someone who retired following the 1990s bull could have been in serious trouble. (These nasty bear markets are what led us to begin creating alternative income streams in the 2000s.)
It’s clear that very long term stock returns, however, average about 10% annually. But most investors near or in retirement will have at least half their investments in bonds. And bonds loose value during periods of rising interest rates, which happen near the end of economic expansion, which typically coincides with bear stock markets. This makes it tricky to rely on the long term annual stock return averages in decades following strong bull markets (and vice versa for periods after bear markets when everyone feels pessimistic).
Again, plan for the worst and hope for the best. I’d rather have too much money than too little because I planned on higher returns than what ends up happening.
To shift the thinking a little, diversified high dividend investment strategies could have a 5.5 to 7% annual return just from the dividends, if left to reinvest and compound.
And real estate rentals can produce significantly higher returns with inflation protection and tax benefits.
This leads me to say the answer to how much money you need to retire is not simply a function of a good retirement calculator. Calculators can provide very good information, but that information is based on rough estimates since we don’t know the future performance of investments or how long we will live.
In this day of low interest rates and underfunded retirement accounts, it pays to be creative. It’s also super important to understand that future returns will be a result of market cycles which are usually tied to economic cycles.
I certainly don’t know exactly what stock and bond investment returns will be in the future. No one does. But I can look to the past and well respected experts as guides. This is what I like to do. It makes sense to me.
Inflation decreases the value of your money by 3%, on average every year. Sometimes inflation is more than 3%, and sometimes it is less than 3%. On rare occasions there are other “flations”, such as stagflation and deflation. But more often than not, inflation occurs at 3% on average each year.
For this reason, I like to assume it will exist. This is another way to plan for the worse and hope for the best. Some investments hold up well during inflation, such as real estate rentals, as mentioned above.
Think of it this way. You’ll want to own some investments that will benefit from rising prices. For example, rents increase with inflation, making rental real estate a good inflation hedge. Certain businesses (stocks) also benefit from rising prices as long as the increasing cost of their supplies don’t offset the benefit.
Fortunately, most retirement calculators factor 3% inflation into their calculations.
I find that most retirement calculators either don’t have enough fields or they are too complicated. I do, however, like this calculator at Vanguard.
What I like about this particular retirement calculator is the way you can see the adjustments visually. This can be very motivating.
What I don’t like is that there is no field for alternative income sources, such as rental income or small business, but perhaps you can enter those into the social security or retirement fields if you have them.
Summary for How Much Money You Need to Retire
Now you’ve considered your expenses, income, net worth, expected investment returns, and inflation. Hopefully you have a better idea of how much money you need to retire based on these factors.
The good news is that most of the factors which affect the amount of money you need to retire are at least partially under your control if not mostly under your control. The sooner you start looking at these numbers, the more time you have to impact your financial future, so I’m glad you’re here.
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Thanks for reading.