Retiring is one of the riskiest financial decisions you will make. On the day you retire, you can calculate your net worth. You won’t know, however, how much retirement savings you need because you don’t know:
- how much you will actually spend on day-to-day expenses
- how much those expenses will be impacted by inflation
- whether you’ll have significant medical or other expenses
- how long you will live or
- what returns you will earn on your investments.
I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out. I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb. We will see what happens.
In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings. As a follow up, I talk about how much you need to save to meet your retirement savings goal in this post.
4% Rule and Multiply by 25 Rule
As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement. In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule. Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing! It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement. Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.
4% Rule for Retirement Spending
The 4% rule is intended to tell you how much you can spend from your retirement savings each year. Let’s say you have $1,000,000 in invested assets when you retire. It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement. In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired. The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.
4% Rule Illustration
The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to long-term average assumptions that are common these days.
As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases. After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.
4% Rule Background
The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning. (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)
Using historical data from 1926 to 1991, Bengen found that there were no 50-year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower. With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years. In only 10% of the scenarios did the money last for less than 40 years.
If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04). In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.
Multiply by 25 Rule for Retirement Savings
The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement. Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings. As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04. It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).
When do you need more or less?
As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.
Your Risk Tolerance
The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).
If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link. It shows how your time horizon (see below) and investment risk impact the 4% Rule.
Life Expectancy and Retirement Age
The analysis underlying the 4% Rule focuses on a retirement period of 30 years. If you retire in your mid-60s, it would imply that you would most likely have enough money to last through your mid-90s. If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).
On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more. The Schwab table above shows planning horizons up to 30 years. Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30-year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.
For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30-year horizon. Multiplying 20 years by 0.1 percentage point is 2.0%. According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years. My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years. You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.
Other Sources of Income
Some people’s employers provide defined benefit retirement plans. These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death. In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post. Similarly, Canadians are eligible for Canadian Pension Plan benefits. Many other countries have similar programs.
When you are estimating how much you need to save for retirement, you can consider these sources of income. If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment. You just need to subtract the income from these other sources from your first-year-of-retirement expenses before applying the 4% Rule (as adjusted for other considerations).
For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits, you would subtract $40,000 from $100,000 to get $60,000. Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings. In this example, you need $1 million less in savings because you have other sources of income.
Unfortunately, most defined benefit plan benefits do not increase with inflation. The math for adjusting the Multiply by 25 Rule is fairly complicated. I’ve developed a simple approximation that you can use that will get you close to the correct percentage. To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your first-year expenses.
You Want to Leave Your Assets to your Beneficiaries
I remember being a teenager and having my father explain to me how much I needed to save for retirement. The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule. (No wonder I was nervous about my finances when I retired!) His logic was as follows:
- Invest in the stock market and get a 10% return. (He did this analysis a long time ago, when stock market average returns, inflation and taxes were all considered to be a bit higher than they are today, but not by so much as to make the logic faulty.)
- You will pay taxes of 40% of your returns, which makes your after-tax return 6%.
- Inflation will be 4% per year. Because he wanted his investment income in every year to cover his expenses without dipping into the principal, he had to re-invest 4 percentage points of his investment return so he would have 4% more investment income in each subsequent year.
- Subtracting the 4% reinvestment from the 6% after-tax return leaves an amount equal to 2% of his investments that he could spend each year (excluding taxes because he separately considered them).
So, if you are like my father, you will want to save closer to 50 times your first-year retirement expenses, rather than 25 times. It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.
Liquidity of your Assets
As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.
As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest. A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan. Other of these assets, such as rental property, could be liquidated to cover retirement expenses. In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.
Irregular Large Expenses
The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home. In addition, end-of-life medical bills can be very expensive.
As you are determining your first-year retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost. For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000. I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations. Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses. In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.
How to Set Your Personal Target
So, what can you do to estimate your personal retirement savings target? Follow the following steps.
Make a Budget for Today if You Don’t Already Have One
It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today. If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there. Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.
Estimate Your Expenses in Your First Year of Retirement
Next, look at your current budget and/or spending and estimate how it would change if you were retired today. On what types of things might you want to spend money in the future that you don’t spend now? Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now? Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.
Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes. If you plan to live somewhere else in retirement, it might have a higher or lower tax rate. In the US, Social Security taxes are 6.2% (12.4% I you are self-employed) of your wages up to the limit ($128,400 in 2019). As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.
Some people say that your expenses will decrease by 20% when you retire. In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money. This post from Financial Samurai provide some insights as to how retirement might impact your expenses.
Increase Your Retirement Expenses for Special Purchases
Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.
Adjust Your Budget for Inflation
All of the amounts you’ve estimated so far are in today’s dollars. That is, they reflect the current prices of every item. You’ll want to increase these amounts for inflation between now and the time you retire. Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently. To adjust your budget for inflation, you’ll want to multiply it by 1.03n, where n is the number of years until you retire. Don’t like exponents? The table below provides approximate multipliers by number of years until you plan to retire.
Subtract Other Sources of Income
If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflation-adjusted budget. My post on Social Security provides insights on how to estimate your benefits for my US readers.
Figure Out your Risk Tolerance and Length of Retirement
If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.
If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.