Almost everyone plans to retire eventually. Whether you want yours to be active or leisurely, you will likely rely on your investments for income at some point. How much money will you need to retire the way you want?
This question is both complex and simple. It’s complex because it involves some factors most people don’t consider. Once you ask the right questions, though, finding the “magic number” is simple math.
The first step is to estimate the annual income you’ll need in retirement. In most cases, this will be less than you spend while working, but not always. Think through all your expenses and estimate on the high end so you have a good safety margin. If you are many years from retirement, be sure to consider inflation. Even 2% yearly inflation can make a big difference over 20-30 years.
Next, estimate the retirement income you will receive from other sources. This should include your Social Security benefits, any defined benefit pensions, earnings from part-time work, and rental/royalty income.
How much will you get from Social Security? It depends on your work history. The Social Security Administration sends periodic estimated benefit statements based on your income history. You can also request one on the SSA web site.
Be wary of depending too much on Social Security estimates, however. Congress could always change the program. By design, the program tries to replace only 40% of the average worker’s pre-retirement earnings. It should supplement your retirement savings, not replace them.
Now, subtract your estimated non-investment retirement income from your annual income estimate. Your investment portfolio will need to generate that much income for you on an annual basis.
Here is an example to illustrate.
$100,000 Annual income needed in retirement
-$40,000 Social Security income
-$20,000 Part-time work income
$40,000 Additional income needed
Investors often have trouble understanding how a pile of assets equates to a future income stream. A good rule of thumb is to build a retirement portfolio valued at 25x your desired annual income.
Remember this 25x multiplier because it is critical. Following it will let you withdraw 4% of your portfolio value each year without touching your principle.
In the example above, you would just multiply the $40,000 additional income needed by 25. The answer is this retiree should have a $1,000,000 investment portfolio, at a minimum, upon reaching retirement age.
From there, just look at your current portfolio size and assess where you stand.
• If you have $600,000 and want to retire in ten years, you need to come up with another $400,000 through additional savings and/or investment growth. Using the “Rule of 72,” annual gains of 7.2% would make your $600,000 double to $1.2 million in ten years.
• If you are already retired and have $1 million or more, you are in good shape. Your priority should be to make sure you don’t fall below that number.
• If you’re already retired and don’t have at least $1 million, you are in jeopardy of eating your seed corn. You need to take immediate action by either cutting expenses or generating more income. Consider some part-time work or a different investment strategy.
In any case, you should have a magic number in mind at this point. The next task is finding ways to hit it. The right strategy will depend on your personal situation, so this is where Republic Wealth would sit down with you and consider all the factors.
You can also use your magic number in reverse to convert your current assets into an annual income stream. For example, assuming 4% annual growth and 4% withdrawn each year,
• $500,000 / 25 = $20,000 annual income
• $1,000,000 / 25 = $40,000 annual income
• $1,500,000 / 25 = $60,000 annual income
• $2,000,000 / 25 = $80,000 annual income
Some investors, and even some professional advisors, might say the 4% withdrawal and growth assumption is too conservative. The truth is none of us knows the future. Whatever rate we use will probably be high in some years and low in others. I always advise Republic Wealth clients against depending on optimistic assumptions. I would much rather see you have a pleasant surprise than find out you can’t afford your dreams.
I mentioned above the possibility of “eating your seed corn.” For those who never lived on a farm, that means you aren’t saving the seeds necessary to grow next year’s crop. Spending your principal is the financial equivalent of that bad choice.
If you go through the planning process to learn your magic number, and you have that much or are at least on track to get there, it’s critical to make sure you don’t dip below your number. For those ages 50 and older, you may not have the time to recover.
How do you do this? You have to balance two competing priorities. First, you don’t want to invest so aggressively that your balance might drop below your magic number in a poor period. However, you also can’t afford to be too conservative. Withdrawing 4% yearly while earning only 1-2% in Treasury bonds is simply another way of eating your seed corn.
Having it both ways is tough but not impossible. A detailed, comprehensive financial plan combined with a prudent investment mix can put the odds in your favor. This is what we try to do at Republic Wealth.
Our goal is actually simple. We want you to sleep well at night. We enjoy helping people identify their magic number, and then watching them reach it.
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