Last week I posted I Set My Retirement Number and Boy It's a Doozy! and I had this comment from a reader:
If you don't mind sharing, I'd like a little more information as to the five methods that you used in calculating the retirement number. I'm particularly interested in the two methods of calculation that you devised yourself.
So here we go -- I'm going to detail how I set my number.
First of all, I googled around a bit and found three retirement calculators that were to my liking. Each of them asked different questions (and thus made different assumptions), so the answers varied more than a bit. However, I recorded the answers provided by Monroe Bank, Money Central and Dollar Times as three data points in setting my number. Then I set off on developing my own estimations in two different ways.
The first estimation was the simple "4% method." It's developed on the premise that you will be able to take out 4% of your nest egg in year one of retirement -- and if you can do this (and live on it) -- you'll be set throughout retirement. So here's what I did:
- I took the annual salary I would need today to retire. (Note: This was not figured as a percentage of my current salary or our living expenses. I simply determined what we would need to live on today based on actual expenses. I did not adjust downward -- as many people recommend -- since I like to be conservative and I assume any decrease in living costs at retirement will be eaten up by increased health care costs.)
- I adjusted for inflation (assuming 3.5% inflation per year) to get the amount I'd need to withdraw the first year I'm retired. In other words, I increased the number I got in step #1 by 3.5% per year for 23 years.
- I then divided this number by .04 (4% -- you can also multiply by 25 -- it gives the same result) and that was my retirement number estimate #4.
For further details on this method, see Will My Savings Run Out in Retirement? where they comment:
If you withdraw 4% of your personal savings during your first year in retirement and adjust subsequent withdrawals to compensate for inflation, you're virtually assured of never outliving your money over a 30-year retirement.
Remember, in my original post, I said I wasn't counting on anything from Social Security, so I have to save this entire amount myself. If I wanted, I could subtract what I already have saved (plus growth of that amount) to see how much MORE I need to save before retirement.
By the way, this method gave me the highest estimate of all the methods I used.
As an example, here's what this method would look like for a person planning retirement:
- Let's say the person decides he needs $50,000 a year in today's dollars to retire.
- In 23 years at 3.5%, that number balloons to $110,306 per year.
- Divided by 4%, $110,306 means the person needs $2.8 million at retirement.
From this amount, the person could subtract what he expects to get from Social Security as well as what he thinks his current savings will be worth at retirement to get how much he needs to save in the next 23 years. For instance, someone counting on nothing from Social Security but who thinks his current portfolio will be worth $1 million at retirement only needs to save an additional $1.8 million (principal and growth) in the next 23 years.
My last method took all of the same steps I employed in the example above, but I just laid it out year-by-year. For every year (from now until I'm 92), I listed the following:
- My income needs (increased by 3.5% annually).
- The value of my current savings. I estimated annual appreciation at 6% to be conservative, but my spreadsheet allows me to change this rate to do "what-if" analysis.
- The value of additional savings -- the amounts I contribute annually to my retirement savings for the next 23 years. These numbers include both the amounts I save as well as 6% annual appreciation.
- A running balance for my retirement funds (the value of my current savings plus the value of additional savings less my income needs)
I then took all five methods, and averaged them to get "my" retirement number. This number was a bit higher than the one I got in method #5, so I felt that it was one that would allow me to reach the savings goals I needed.
I end up with lots more money when I die at 92 than I had at 65 when I retire -- my needs are just not as great as the growth of the amount I'll save. This could be looked at two ways:
1. I'm saving too much and thus don't need to put as much away.
2. This protects me against potential snags in my assumptions (what if it costs more to live than I estimate, what if I can't get the annual returns I have estimated, etc.?).
Finally, this number is not set in stone. I will re-visit it in 3-5 years, see how I'm doing and make any needed adjustments. I hope to put in more than planned in the next few years to really boost my savings, so hopefully that review down the road will show I've made good progress towards my goal.