In this post, I want to get a little more specific about how to better understand and assess your own situation and challenges.
There are some strong headwinds.
To address any challenge we have to first be willing to understand and accept the realities of the situation, even if they’re hard ones. Our financial condition as we plan for or enter retirement is no different.
Retirement stewardship can be very challenging because there are things that are outside our control that create strong headwinds against progress. These challenges introduce what is known as “longevity risk” – the risk that you will outlive your money. Longevity risk has actually increased for many people in recent decades due the following contributing factors:
- We are living longer and longer. According to the Social Security Administration data, a 65 year old man who retires in 2015 can expect to live, on average, until age 83 and the average 65-year-old woman will live until 85. On average, that means almost 20 years in retirement for both, and some will live much longer.
- Fewer of us have pensions. According to the Bureau of Labor Statistics, fewer than 20% of us are currently covered by an employee pension plan. (Most are government employees.) That’s down from 35% in the early 1990s.
- Inflation and healthcare costs will take a big bite out of savings. Even if inflation only averages 2 to 3% a year, that means that $1.00 saved in 2015 will only buy $.65 worth of goods and services 20 years from now. Even worse, healthcare costs (supplemental insurance, co-pays, deductibles, etc.), which are estimated by Fidelity Investments to average over $200K per person during retirement, are actually increasing at a higher rate.
- Social Security may not be around, at least not in its current form. There are valid concerns about the future of Social Security, at least as it is currently constituted. And even if it remains, it is not meant to cover the majority of your living expenses while in retirement.
I list these things not to cause you to fear, but to help you understand the things we all face as we move into our retirement years. They all point to one main fact: You should probably be saving more than you are.
Let’s go back to our make-believe couple, Mike and Debbie. (If you don’t remember them, just revisit the first article in this series.) They are in their mid-to-late-50s and have approximately $100K saved for retirement. Assuming they continue to save and invest wisely, that number should grow, perhaps doubling by the time they are in their 70s. But will that be enough; how can Mike and Debbie know what is “enough?” It may be more or less than they think.
How much is “enough?”
Having “enough” can be viewed in different ways. For some, enough means having just what is needed to cover basic necessities. For others, enough means having more discretion in terms of giving, pursuing hobbies and recreation, leaving something behind, etc. For most retirees, the main concern will be paying the bills, but many of us hope to have some discretionary leeway and perhaps even leave something for others after we pass on into eternity.
Well, there’s no simple answer. You can use an online retirement calculator that makes a fairly complex calculation based on current age, income, savings rate, inflation, time to retirement, etc., to come up with your savings target. The tools will also tell you where you should be currently and what you need to save to get caught up. (See my suggested list of retirement calculators on the Resources page.) Or, you can just use some basic guidelines.
Fidelity Investments estimates that to retire at age 67 and replace 85% of your then current income you should have saved 1X your salary at age 30, about 2X your then-current salary by age 40, 4X by age 50, and about 6X by age 60. These calculations are based on a long list of assumptions, such as you starting to save 6% of your salary at age 25, increasing your contributions by one percentage point a year until you hit 12%, with your employer contributing 3% to your account every year. It also assumes that you work continuously until age 67 and that your life expectancy is to age 92. They also make assumptions about earnings (5.5% per year), salary growth (1.5% per year) and the general inflation rate (2.3% per year).
Applying those guidelines to Mike’s and Debbie’s situation, they should, at age 57, currently have approximately $350K saved for retirement. Their current balance of $100K is somewhat less. If they are making $100,000 at age 60, they should have around $600K socked away. Fidelity says you will need approximately 8X your annual salary when you retire at age 67, which would be $800K if their salary didn’t change between 60 and 67.
A popular rule of thumb, which is based on the “4% withdrawal rule in retirement”, is that you will need to save 25 times your annual expenses in retirement net of any Social Security, pension, or other payments in order for your money to last another 20 or 30 years. In other words, if you decide you will need $75K per year in retirement, and will receive $25K per year in Social Security, that leaves $50K to fill the “gap” so you will need to save approximately $1.25Mil. (25X $50K in living expenses). Interestingly, that number is double the Fidelity Investments estimate!
Another study by Aon Consulting estimates that a 67 year old will need about 11 times their income to replace 80 to 85% of income. In the example above, that would put the target at $550K, still far less than the 4% rule estimate.
These numbers are not absolute, meaning they are really just guidelines. A couple with an annual income of $100K who retires at age 65 may find that they can live on much less and don’t require $1.5Mil. in savings. Perhaps they adjust their lifestyle such that they can actually live on $50K per year (which, incidentally, is the average family income in the U.S.) If so, they will need much less. Based on the 4% rule discussed above, they would “only” need $625K in order to generate $25K per year in income, which combined with $25K in Social Security benefits, is $50K total income per year (before taxes, of course).
It is important to remember that none of this may actually fit your situation. That’s because they are all based on a certain set of assumptions that may not be true for you. As Fidelity noted, “Every individual’s situation will differ greatly.” So, it’s best to proceed with extreme caution in using these guides or any of the many retirement-savings calculators and guides that are available.
What is your “number”?
In light of all this, how can you arrive at a number that is “enough” for you? Here’s a relatively simple approach that may help you:
- Estimate your living expenses in retirement. You could use an 80% of current income approach and adjust that percentage up or down based on your individual situation. (The more conservative you can be in estimating your living expenses the better. But depending on how far you are from retirement, don’t forget to take inflation into account, which averages 2 to 3% per year, and also the likelihood of increased healthcare expenditures.)
- Estimate the amount of any income sources you will have other than from savings. This would typically include things like Social Security, any pensions and rental income, or even part-time work. (If you haven’t received an estimate from Social Security, you can go to socialsecurity.gov to get one.)
- Estimate your retirement income “gap. To do this, subtract the amount from step #2 from your estimated expenses in step #1 to determine the “gap” between what you need to live on and your income sources in retirement other than savings.
- Estimate how much you will need to have saved. Take the amount from #3 and multiply it X25. (That makes the calculation based on the so-called 4% “safe withdrawal” rule.) The reality is that you will probably need a nest egg between 20-30 times the amount from #3. Where in that range you fall will depend on your age (the earlier you retire, the more conservative you can need to be), your views about your future and your investments, and your lifestyle flexibility in retirement.
Before we go any further, I want to caveat step #4 above. The “4% withdrawal rule” is one of much debate in financial planning circles these days. It is increasingly being called into question because it was formulated during a different economic climate. Many now think that setting a fixed withdrawal rate with an annual adjustment for inflation and sticking to it for your entire retirement is no longer realistic. I tend to agree, but it is still a good way to come up with an initial estimate.
There are multiple alternatives. You can use fixed or variable withdrawal percentages, and there are different flavors of each. Or, you can annuitize some or all of your savings (which may be especially helpful for those with less savings and need to maximize income). If your nest egg is large enough, you can try to preserve capital by living off just the interest, dividends, growth, and some part-time work. However, for those who are behind in saving for retirement, that may not be possible.
I would recommend that you use the 4% rule as a general guideline to make some rough estimates while realizing that you will need to remain flexible in terms of how you will determine how much you can withdraw from savings year-by-year when you are actually in retirement.
What about Mike and Debbie?
Using this approach, let’s see how our make believe couple, Mike and Debbie, might do in terms of being ready for retirement:
- Living expenses: Mike’s and Debbie’s current income at age 57 is $70K. For this example, we’ll estimate a salary of $91K at age 67 (assuming 3% increase annually). For simplicity, let’s assume that their expenses are equal to their income. (If they are less, then all the better.) Based on the 80% guideline, their expenses in retirement would be $72.8K.
- Other income: Estimated Social Security income 10 years out (adjusted for inflation) would be approximately $40.3K for Mike and $20.1 for Debbie (50% of Mike’s based on the spousal benefit), for a total of $60.4K per year. Mike and Debbie don’t anticipate any additional retirement income.
- Income gap: Their living expenses of $72.8K less estimated Social Security income of $60.4K leaves an annual income “gap” of $12.4K in retirement.
- Savings needed: Multiplying $12.4 X25 (based on the “4% rule”) results in an estimated amount of savings needed of $310K.
(Calculations made using the simple online calculators available at bankrate.com)
We already know that at age 57 Mike and Debbie currently have $100K saved. If they can increase their savings to 20% of their gross income and earn an average of 7% per year on their investments, they could expect to retire at age 67 with approximately $390K, which would exceed their goal of $310K. Of course, this depends heavily on their ability to save much more and also to earn an average of 7% per year on their investments for the next 10 years, neither of which may be possible.
If Mike and Debbie are only able to save 10% per year, and they earn 5% on their investments (both may be more realistic assumptions) and have living expenses of 100% of expenses as they enter retirement, their situation will be very different. Their savings would be approximately $255K, and their annual income gap would be $39.6K. Annual income from savings (based on the “4% rule”) would be $10.2K, which would be well below what is needed to fund the gap.
So, to put it bluntly, Mike and Debbie would have significant challenges making ends meet without any additional resources. However, we have actually overlooked one important additional source of income: their home equity. We will take a closer look at that in the next article.
From this simple example, we see that a couple in their mid-to-late- 50s who are a behind in saving can make up for lost time and have a viable plan in place IF they ramp up their savings, get reasonable rates of return, keep their expenses in check during the years leading up to retirement, and then reduce their expenses during retirement. Of course there are a LOT of assumptions baked into this example that may not hold true for you. And as I have stated before, every person’s situation is different, but generally speaking, the more conservative you can be (such as using a X30 multiplier in step #4 instead of X25), the better.
Read the next article in this series: Behind in Saving for Retirement? (Part 5)