Thursday, October 1, 2009

How Much Money Will You Need To Retire??

How much in savings will you need to retire? A lot -- even many of you who are among the vanishing breed of employees who have traditional defined benefit pension plans. In this post I will introduce a spreadsheet to help you estimate the amount you need to save. I'll also provide a simple rule of thumb for those who prefer a shortcut. (see Rule of Thumb below)

Retirement planning: Savings needed vs life expectancy graph
Retirement Savings Needed vs Life Expectancy
This series of posts will not only help you estimate how much you will need to save, and help you develop a plan to save that much, it will also help you understand the whys. Understanding the issues, and the assumptions that traditional retirement planning software packages typically make will, I hope, decrease the chances that you will misinterpret or misuse their results; this, in turn, will increase the chances of your living the retirement of your dreams.

How Much Will You Need in Retirement Savings? (In Then-Current Dollars)

For many people, the biggest savings challenge they will face is
saving for retirement. The chart above (click to expand) shows the estimated savings needed for a hypothetical 25 year old, Pat, planning to retire at age 65 with living expenses of about $45,000/year in today's dollars. (Note: the $45,000 is after tax spending, not income.  If you plan to spend less than that in retirement, or have a traditional pension, or your employer matches some or all of your savings, or are more optimistic than Pat regarding the future of social security, or you expect less than 3% inflation, you may need to accumulate much less in savings.)  The solid red lines assume Pat's investments are in taxable accounts; the blue dashed lines assume the investments are in tax-deferred accounts such as IRA or 401k accounts.

As you can see, Pat will need about $2 million to fund retirement expenses to age 85 if the investments are in taxable accounts -- somewhat more if the investments are in tax-deferred accounts. Remember, those amounts are in then-current dollars. At 3% inflation, $2 million 40 years from now is the equivalent of "only" about $600,000 in today's dollars.

The downward slope of the curves reflects the fact that, as a rule, the fewer years remaining to live, the less money needed. For example, not surprisingly, Pat will need less in savings at age 75 than at age 65. The curves that end at age 100 illustrate the fact that it will take significantly more money to fund 35 years of retirement expenses than to fund 20 years.

Retirement Planner Assumptions

Maybe a better answer to "How much money do I need to retire?" is "It depends." The amount you will need to save depends on a surprising number of factors -- most of which are difficult or impossible to predict. Below is a table of the input data used (click to expand) to produce the above graph.

Retirement planning: Savings needed assumptions
Retirement Savings Needed Assumptions
Note: Click on the above screenshot to expand it. The link to download the spreadsheet is at the end of the post.

Most people are relatively comfortable estimating their retirement age and their expenses in retirement. At the other extreme, however, are critical inputs that you may find very difficult to estimate, and over which you may feel you have little or no control -- your return on investment, inflation, and life expectancy (a euphemism for when you will die). In between are other important variables that you may or may not feel comfortable estimating, such as social security, pension income and tax rates (see link below for help on estimating social security). In fact, the only input that you can likely provide with certainty is your current age.

Introducing The Observations Retirement Planning Calculator/Spreadsheet

The retirement planning calculator/spreadsheet introduced in this post is similar to other traditional planners that you will find. (See the end of this post for links to download the spreadsheet.) A key thing to remember is that the results can only be as accurate as your input. As a result, the reality is there is no way to know exactly how much you will need to save. For starters, you'd have to know how long you are going to live! Even so, I found a simple planner like this useful -- especially early in my career.

Another problem with models like this one is how they handle return on investment (ROI). Traditional models assume your ROI will be the same year after year. If you've been following my series on stock market returns (see, e.g., Stock Market Yearly Returns) -- or keeping up with recent stock market performance in the news -- it should be clear that the real world doesn't work that way. Unfortunately, the fact that it doesn't has huge implications on retirement planning. In a future post, we'll explore ways to deal with these issues more effectively.

A Conservative Rule of Thumb for How Much You'll Need to Save

In the meantime, here's a shortcut that many find useful. A common rule of thumb that more and more financial planners recommend is the 4% withdrawal rate. Withdrawing 4% of the portfolio in the first year of retirement is a plan that should work for a broad range of retirees. It follows that, using this plan, you would need savings equal to 25 times what you plan to withdraw from savings in your first year of retirement. This is a more conservative approach, and generally recommends savings larger than those recommended by the traditional, deterministic models. (In Pat's case the recommended amount is $3-3.5 million.)

(For a retirement planning spreadsheet based upon withdrawal rate, see A Simple Retirement Savings Calculator/Spreadsheet. Or, for an even simpler approach, see the graph in How Much Savings Will You Need to Retire? which is based upon that spreadsheet.)

Note that the same factors still determine your needs; you just don't get a chance to specify them. For example, you'll notice that nowhere do you specify your expected return on investment or life expectancy. The method gives you a reasonable target under a broad range of circumstances, but it's not magic. If you're planning to invest all your savings in Treasury Bills, retire at age 50 and live to 120, this method won't give you a reliable savings target.


Most people will require substantial amounts in savings in order to retire comfortably -- especially if they do not have a traditional "defined-benefit" pension. Saving such large amounts will require a long-term saving and investment plan. The good news is that accumulating this much money is probably easier than you think.  The next post will help you develop a saving plan by addressing the question What Percent of Your Salary Should You Save? (For a simpler approach, see below.)

Other Related Materials:

Easy-to-use Retirement Planning Graphs based upon the 4% Withdrawal Approach:
My SIMPLE Retirement Savings Calculator/Spreadsheet: my "back-of-the-envelope" approach used to generate the above graphs.

A Retirement Planning Calculator/Spreadsheet : Adds even more capabilities to the retirement planning spreadsheet discussed in this post. (version 3)
How Long Will You Live? Intro to one of the most vexing issues in retirement planning.
Stock Market Yearly Returns Since 1929
100 Years of Inflation History: Inflation is one of the biggest threats to retirement.
Range of Stock Market Returns for 1-100 Years
Social Security Income Estimator : the official site.  For an approximation, see this site.
Do You Need a Personal Strategic Plan?: Your retirement plan should be part of an overall personal strategic plan.

Link to Spreadsheet

Here's the link to download the Excel spreadsheet: Al's Simple Retirement Planning Model (version 2). If you have any problems accessing or using the model, see this post.

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