Why Working Backward May Help You Save For Retirement
News Team
If you are still years away from retiring, then making sure you save enough money to support yourself when you get there is probably at the top of your mind — and it should be.
But in order to know whether or not you are saving enough, you first need to have an idea of how much money you’ll need when you get there. Then, you can plan backward from there to make sure you hit your target.
How Much Will You Need to Retire?
First, think about how much money you’ll need to retire. I’m talking about the lump sum of savings you’ll want to have set aside and earmarked for funding your expenses when you quit working.
It’s a complex question that will require you to do some estimating and make some assumptions. You’ll want to do some considerable research to know how you want to account for each of them.
I’ll explain the basic process for figuring it out but know that this will take you some time to explore and decide exactly how you want to address it in your own plan.
How Much Will You Need to Spend?
Your savings target should be the amount of money that will support your planned spending in retirement. That’s incredibly easy to type and say but will require more thought to implement.
Naturally, you’ll need to have an estimate of what your spending needs will be. Notice I said estimate. Nearly every part of your retirement plan involves making estimates of what the future will look like for you. Knowing your current budget helps because you can adjust from there. Don’t forget to think about taxes, inflation, or how your lifestyle might change.
Once you have your spending target, don’t forget to account for any sources of retirement income that aren’t tied to your savings such as Social Security or pensions.
So that we can tie this all together at the end in an illustration, let’s assume that you think you’ll need to have about $7,000 per month in retirement income. From there, let’s also assume that your estimated Social Security (or teacher pension, or employer pension…) benefit is $2,000 per month. Subtract your guaranteed payments from your total need to get the amount you’ll need to withdraw from savings each month. In this case that’s $7,000 – $2,000 = $5,000.
$5,000 becomes your estimated monthly savings withdrawal, or for the year, $60,000.
Now you can keep working through the next step in the process.
Your Withdrawal Plan
How do you plan to withdraw money from your savings when you retire? I’m not talking about the logistics of getting money from your 401k into your hand, but again, the planning considerations for determining how you will withdraw.
There are many ways to do it, each with pros and cons. You can take a fixed amount of money each year, you can allow your withdrawals to vary with market conditions, build a bond ladder, or buy a product that pays you according to a formula (annuity), to name a few. There is a lot to research in this area.
For purposes of illustrating the explanation, I’ll use a popular method called the “4 percent rule”.
Again, I’m simplifying some here so I don’t lose you in this basic overview, but the 4 percent rule essentially says you will withdraw 4 percent of your account in the first year you retire. You then adjust your withdrawal for inflation each year after.
If you are using the 4 percent rule, then you can pretty easily determine how much money you need to have saved when you reach retirement age. It’s whatever amount of money your planned distribution is 4 percent of.
Going back to the illustration we began in the previous section, consider that $60,000 you need to withdraw each year. What is $60,000 4 percent of? Simply divide $60,000 by .04 to get $1,500,000.
You now have your general savings target.
Your Expected Return Rate
Now that you know the target you are aiming for, you can start to think about your path to getting there.
As you save, you should expect at least some reasonable rate of return on your balance. Finding what that reasonable rate is requires you to estimate.
The primary consideration for estimating your expected return is how you invest your savings. Again, that’s something else you’ll need to think about critically. You need to consider your appetite for risk and how long you have until you retire. The important thing I want to stress here is that your return estimate should be reasonable based on your investment plan.
For example, if you are a very conservative person and invest in nothing but certificates of deposit at your bank or US Treasury bonds, don’t use 12 percent as an annual return estimate. Likewise, if you have a larger appetite for investment risk, are still 10 or more years away from retirement, and have a large portion of your investments in equities, then you likely won’t be looking at a 3 percent annual return.
You can consider the historical investment returns for the way you invest to give you some point of reference, but don’t blindly assume that you’ll get the exact same going forward. To account for this, you may want to consider variability or the chance that you’ll get exceptionally high or low returns — or just use something a little lower than what you expect.
Here’s what I mean by that: Suppose you think you can reasonably expect to earn 7 percent per year on average based on the way you invest. You may want to consider a range of investment returns around that — say from 4 to 12 percent. (I chose that range randomly; don’t attribute any particular significance to it.) Or, if you expect to earn 7 percent per year, maybe you just choose something lower like 6 percent to err on the side of caution.
I like to employ a process called Monte Carlo analysis. It statistically estimates a range and sequence of future investment outcomes based on the specific investment portfolio being considered, and does so for 1,000 “trial runs.” You can then consider how many of the trial runs result in a successful retirement as a way of estimating your chance of success on your current path.
Putting It All Together
To come full circle, remember that the purpose of this article is to help you get an idea of the process of how to work backward to create a savings plan.
Taking the estimates from the illustration I wove throughout, suppose:
You think you’ll need $7,000 per month in retirement, and will receive $2,000 per month from a guaranteed source. You’ll need to withdraw $5,000 per month, or $60,000 per year.
You have decided you’ll use the 4 percent rule, so you need $60,000/.04 = $1,500,000 saved when you retire.
You think you’ll earn 7 percent per year.
Now you just need to plot your path from point A (where you are now) to Point B ($1,500,000).
To finish out the illustration let’s assume you are 50, plan to retire when you are 63, and have $800,000 in your 401k. You can use an excel spreadsheet or future value calculator like the one here to calculate your annual savings needed to reach your goal.
With 14 years left to go, and making the assumptions we have in the example, you need to save about $14,077 per year to have $1,500,000.
If this example doesn’t resonate with you… that’s OK. I pulled these numbers out of my head randomly as I typed this article. The process and thought behind the considerations are what is important. Everybody and therefore every financial plan is different. Update and adjust based on your own situation.
