Rules of thumb & Calculations for Retirement
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Legend:
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Ah yes, a favorite and simple to understand yet difficult to master concept: calculating how much money one needs for retirement. For this, for the average person (even for folks somewhat allergic to math) I would point those people towards the book “Risk Less and Prosper” by Zvi Bodie and Rachelle Taqqu.
However, while you’re waiting on that book to arrive via your library, a friend, or you know… amazon, sit down, have a cup of (insert your beverage of choice here), and read along…
For those of you eager to retire early it comes down to a few things. The following is a slightly adapted version of what you’ll find at ERE (Early Retirement Extreme) I added the bold words below:
“One’s savings rate is the sole determinant for how many years it takes to become financially independent. (Complete with formulas)
For most people, it is relatively easier to decrease expenses than increase income.
The smartest way to do this is to focus on the big expenses (typically house, car, medical expenses, taxes, utilities, and food) instead of clipping coupons or relying on long lists of penny-pinching frugality tips.
Early retirement is not just for millionaires or the 55+ crowd.”
Personally, I consider medical spending to be a necessity. I would rather live, thank you very much. Yes, you can reduce these by living a healthy lifestyle, but they will not go to zero. Taxes, if you are alive (and even if you are dead) will be there, I promise. You can reduce these too, but they will not be zero. Utilities are more subject to debate. Yes, you could live in a log cabin. You could also have solar panels (I assume those would cost you money to build, but you know: I could be wrong.) For many people, their utility costs are likely to be higher than zero at some point, even if that point is in the distant future when they are too old to live in said log cabin.
So, if you’re the traditional person you have needs. The big 6 items for nearly all people on average seem to be (in no particular order, but generally by most to least expensive in my opinion):
Medical Expenses (incidentally in the US this is the #1 cause of bankruptcy)
Housing Expenses
Taxes
Food
Transportation
Utilities
So, if you find that you are saving for retirement/financial independence, these costs are where you start looking hard first. You also want to be conservative with them. The big 6 are where you should be focusing your time and energy on cost cutting and efficiency measures.
Now, you might notice a thing (or two or three) missing here. One big one? DEBT. I’m assuming that your debt (all sources) is paid off or that you never had any in the first place.
If it’s not, focus on paying off your debt first ALL of it, and then focus more on retirement afterwards. Like any rule of thumb there could be exceptions. For instance, if your only debt is a mortgage and it’s a 30 year fixed rate mortgage at 2.5%, you have less than $100,000 left on it, and you can take that amount and buy a 5% US Treasury Bill for the same duration as the mortgage, then guess what? It might make more sense to do that than to pay off the mortgage.
🐻But in general, that’s not what we’re talking about here. For some of you, you may still have student loans, you may have credit card debt, etc. If you do, pay that off, keep it paid off, and never go into debt ever again.
Rules of thumb for calculating what you need
*with some caveats
Charles Schwab has some of the basic concepts around this here
but I’ll save you the trip:
STEP ONE - How much will it cost?:
Figure out what your “needs” are. Meaning things you need to survive.
Figure out what your “wants” are. The things you want that you wouldn’t want to live without. This varies wildly from person to person. You may discover that some of your “wants” you don’t want after all once you realize it would mean working 2, 3, or more years for that “want”.
Calculate how much your needs and wants are cost wise for an entire calendar year. This combined total represents your spending for one year.
✙ ^ Regarding the last bullet here, keep in mind that as of 2023: “The average couple may need $315,000 to cover health care costs in retirement” and this is only for folks retiring at 65. So be careful with assuming things here. You could get cancer, you could have a car run into you one day, you just don’t know.
STEP TWO - How much will I need to save?:
Multiply that 1 year combined total times 25. That number is how much you’ll need in savings minimum for retirement. This is just a rule of thumb. You could end up needing more you might end up needing less. This is just a starting point. But a pretty decent one in my opinion. If my friend, Big Sixington’s spending was $48,000 per year. It would be:
$48,000 x 25 = $1,200,000 of minimum savings needed for retirement.
If this looks like a large amount, it’s because it is. But remember, for those of you in the US, you have Social Security. You can calculate your expected benefit here. As of this writing by LAW, you WILL receive some kind of benefit if you have 40 credits in system, regardless of what any weird talking head on TV may tell you. You also will have some cost of living adjustment for inflation as well. It may be more or less than what you’d get today, but regardless, it will be there. Plan on it.
Another rule of thumb you can look at is assuming a 4% withdrawal/spend rate for your first year in retirement on your lump sum.
4% of 1,200,000 = 1,200,000 x .04 = $48,000
Simple enough right? Well… not really. This is a starting point. For many reasons. Firstly, it depends on how your funds are invested. If you’re mostly in stocks there is a risk that if the market goes down in the first few years of your retirement, you could run out of money. To be on the safe side, you would withdraw less (and……… perhaps much less) than 4% in the first few years since you are in riskier assets.
Conversely, to take an example from “Risk Less and Prosper”: “An annuity quote for inflation-adjusted monthly income of $500 in exchange for a onetime payment of $100,000 translates to an inflation-adjusted $6,000 a year, and a withdrawal rate of 6 percent.” IF an annuity is properly chosen with care, AND NOT LINKED to the stock market, then a withdrawal rate of more than 4% is possible, even if the stock market tanks in the same period. Furthermore, the 4% rule generally is used for a 30 year horizon. Not for say, 60, 70, or more years.
So if you’re planning for a longer period, more can go wrong, and you could run out of money. But if you’re really young, you could mitigate this by starting a gig, or business, or working part time, once you reach your number. A ‘retirement lite’ if you will.
One rule of thumb you may encounter is 🐻 "You should have 100 minus your age in stocks when retired." This is DUMB. Age on its own without any context has nothing to do with your risk profile or how you should or shouldn’t be invested.
What matters is how much money you KNOW you need, and how much you have saved for retirement, and if the lowest risk rate on say, I Bonds, can cover that. Keep in mind, you can buy as many I Bonds as you wish for a small fee, as long as you open multiple LLCs to buy them. Now, if you have more money saved than what you know you need for retirement, then the portion beyond what you need you could theoretically risk in the stock market or other more speculative securities. That’s because that amount of money could decline to zero and it wouldn’t affect your lifestyle.
Here’s an example of the above: Let’s say Big Sixington has $1.8 mil saved up for retirement. This is 600,000 more than they need. In theory (again with caveats) Big Sixington could take this 600K and put it into stocks and if they all went to zero, it would be fine.
STEP THREE - Putting it all together:
Now by this point you should know: 1. How much spending you have per year 2. How much money roughly you’d need to have saved to support that spending. Number 3 is (drum roll) saving up that amount. There are lots of ways to do this but it comes down to: cutting your costs, increasing your income, and automating your savings so that you aren’t spending it. Whatever works for you basically. Tracking your goals is important too, to make sure you’re… you know… on track.
For something so critical it is vital that you check and recheck and re-re-re check your calculations over and over again, and continue periodically doing this in retirement too. Depending on your background, you might also pay a fee only certified financial planner a one time fee to “sanity check” your plan to make sure it passes muster. I would recommend fee only certified financial planners that believe retiring early is possible. Some don’t believe this for reasons that don’t have anything to do with good math.
Here are some calculators that can also be a starting point for showing if you’re on the right track with your assumptions:
Fire Calc (be sure to read the assumptions)
Oh, and do yourself a favor and read “Risk Less and Prosper”