« Inflation and Your Retirement Plan | Main | The Frugal Duchess to be on the Radio »
How to Calculate Your “Number”
By JLP | December 1, 2005
I’ll be posting about topics related to Lee Eisenberg’s The Number
Yesterday, I showed how inflation can really impact your future income needs during retirement. Today, my goal is to show you how to calculate how much money you will need to accumulate in order to finance your retirement income needs. It’s a fairly simple formula but it depends on several factors. Some things to consider when calculating your Number are:
- How much income can you expect from Social Security and at what age can you expect it? The younger you are, the more likely it is that you will have to wait longer before you qualify for Social Security.
- Can you expect to have monthly income from a company pension? Be careful with this one. Companies have found ways to take pensions away. I would be extremely conservative with estimating pension income. In fact, I would even consider planning without the pension income and if you end up getting it, consider it a bonus or a gift. You don’t want to make the mistake of planning on a $2,000 per month pension and then get to retirement and find out it’s not there.
- What are your chances of inheriting money from your parents or grandparents? Again, I WOULD NOT base my retirement plans on an expected inheritance.
- Will you work during retirement? If so, how much can you REALISTICALLY expect to make?
Those are some things to think about while you are trying to figure out your Number.
For this example, we will assume that you want $100,000 in income and that you want to fund all $100,000 with your own retirement savings. We’ll assume that you are 20 years away from retirement and you expect a 3.5% annual inflation rate over the next twenty years. Looking at the chart from yesterday’s post, we can see that you will need $198,979 in income in order to have the same purchasing power of $100,000 today.
Now, to find out how much money you need to be able to fund that $198,979, we simply divide $198,979 by your desired withdrawal rate. What is a withdrawal rate? It’s the percentage of your account that you want to withdraw for income needs. Here’s what the formula looks like:
So, for this example, we will plug in the numbers that we know into the equation so that it looks like this (we’ll assume a 4% withdrawal rate):
If you remember your algebra, you can solve for the account value by dividing $198,979 by .04, like this:
So, what does this tell us? It tells us that if you desire an income of $198,979 and you only want to withdraw 4% of your money per year, then you will need to have $4,974,475 in your retirement account by the time you retire. Also, it is important to note that if you want your income to keep pace with inflation, you will need your account to grow at least 7.5% per year (4% withdrawal rate + 3.5% inflation rate = 7.5%) in order to keep you from eating into your principal.
Next time, we will go into more detail about withdrawal strategies.
Topics: Retirement Planning, The Number | 8 Comments »
December 1st, 2005 at 7:23 pm
One important thing missing in these discussions is how to come up with the number in the first place. Do you actually need to burn through $100K in current dollars every year in retirement? That’s more than enough to keep you in the country club, particularly if you do the right things and pay off the mortgage, have the kids through college, and have no ongoing debt.
Having a country-club retirement is nice – particularly if you already are used to this sort of life – but to say that you need an amount in the corporate jet range to do so will just scare people to vote for bigger SS payments and to heck with the national consequences. If you start with an amount to keep you in a comfortable but more midsize retirement, the number won’t seem so impossibly daunting.
December 1st, 2005 at 7:31 pm
Foobarista,
You are right but I can’t possibly run all the various scenarios. If someone only needs $50,000 per year in today’s dollars, then they can pretty much figure out that their Number is going to be half of the number in the example.
There’s no doubt that people can have a comfortable retirement on less than $100,000 per year.
December 1st, 2005 at 11:32 pm
Why would you want your portfolio to keep pace with inflation + withdrawal rate? In other words, why would you want your portfolio to stay constant through retirement? Why would you want to die with $4 million in the bank? I must be missing something here.
December 1st, 2005 at 11:39 pm
Dave,
Good point. Some people may not want to leave $4 million. In that case, they can draw down their principal if they so desire. However, they have to be very careful doing so because once their principal is gone, it’s gone. What happens if they draw down too much and live too long?
I’m not an advocate of annuities of any type but in this case, a person in this case might be suited for a fixed immediate annuity for a portion of their savings.
December 2nd, 2005 at 2:25 am
Hi JLP:
Partial annuitization of a nest egg is likely to be an important part of most investors distribution strategies.
If you read the three studies I have linked (as well as the news article showing net worth stats) you might agree with this statement. Moshe Milevsky and John Ameriks are leading authorities on the subject. Monte Carlo analysis, utility functions, and quantative risk assessment all suggest considering low cost immediate annuities in the payout calculus.
On the fixed immediate annuity side, Vanguard offers an inflation-indexed immediate annuity. Both Vanguard and TIAA-CREF offer graded annuities.
On the variable immediate annuity front, Vanguard, TIAA-CREF, and now Fidelity offer low cost vehicles (Vanguard being the lowest cost).
Check my post for details.
regards,
Barry
January 8th, 2006 at 7:00 pm
Some minimum pension should be covered by Pension Guarantee Corp.
The 4% withdrawal assumes a portfolio about 60/40 stock, bond. or conservative, lower withdrawal.
Fixed pensions should be discounted for inflation, spend part aand re-invest the rest.
January 8th, 2006 at 7:01 pm
Expected real returns, taxes deferred or paid from work while saving, less fund costs
Saving Withdrawal (tax based on nominal return)
Stocks = (1/pe) – fund costs -2 – taxes
Bonds = yield – inflation – fund costs -1- taxes
Actively managed funds may have extra costs equal to their published expense ratios.
Often 0% net real return after taxes by late life from ever more conservative portfolios.
September 13th, 2006 at 4:15 pm
“Why would you want your portfolio to keep pace with inflation + withdrawal rate?”
If you retire at 65 and live to 95, retirement lasts 30 years. Most people are aware that early in a 30 year mortgage, most of your payment is interest. As a result of the same math, there’s little difference between the amount you can withdraw from retirement savings and maintain your principal indefinitely vs. the amount you can withdraw if you plan to draw the principal down to zero in 30 years.