Do you wonder if you are saving enough for retirement? It’s probably the most fundamental question you can ask yourself if you’re still working toward it. It’s probably confusing, too, because it seems like everything you read gives you a different answer. The thing is, the answer is different for everybody. You need to know the right answer for you.
A simple strategy for figuring this out is to work backward. First, figure out how much you think you’ll spend in retirement. Then, think about the amount you’ll need to have saved to be able to support that level of spending. And lastly, estimate how much you’ll need to save along the way to get there.
There are a lot of variables that come into play, and you’ll have to make some reasonable assumptions about things like how long you’ll work, how long you’ll live in retirement, investment returns, and inflation.
But it’s important that you go through this process; otherwise, you’re leaving too much to chance… and crossing your fingers isn’t a retirement plan.
1. Estimate Spending
First, estimate how much you’ll need to spend each year. Before you even begin this process, understand that what you come up with won’t be exact, and that’s OK. It’s just a well-thought-out estimate that at a minimum allows you to get in the ballpark. The closer you get to retirement, the more accurate your estimate will be, because less will change. In other words, if you’re 50 and plan to work until you’re 65, then some things are going to change. If you’re 64, not as many things will.
So, where do you start? Think about how much you spend currently, what you spend that money on, and how you think that may change once you retire. For example, maybe you have employer-provided health insurance but will need to pay for Medicare when you retire. Or, you’re saving in your 401k but, of course, that will stop once you retire.
At this stage, I don’t encourage you to try to trim things from your budget or underestimate your spending. If you do, you may find out later that your estimate wasn’t realistic. It’s better to plan on needing a little more than a little less for now.
Don’t forget to account for any spending that will be covered by Social Security, pensions, or any other reliable retirement income that won’t depend on your savings. You can subtract these items from your expected spending because you don’t need to save separately for them.
2. Withdrawal Plan
Once you have your spending estimate, you can then figure out how much you’ll need to save. Knowing how much you need to have saved is crucial because it provides you with a target.
To do that, you’ll need to have an idea of how you plan to withdraw from your savings. There are a lot of different ways you can do this. You should take some time exploring the various retirement withdrawal strategies because they all address different preferences regarding risk and certainty. Again, what you decide now may not be exactly what you do once you reach retirement, but it gives you a basis to plan from.
The most popular method that many retirees use as a basis for determining their retirement spending is the 4% rule. There’s a lot to think about even with a simple rule like this, but the rule basically says that you withdraw 4% of your savings in the first year you retire. Each year after, you adjust the amount you withdraw for inflation.
As I said, there’s a lot more to it than that, but the point here isn’t to explain the 4% rule or suggest that you should use it. I’m merely pointing it out as an option and showing you how you can use your chosen withdrawal method in the process of figuring out how much you need to save.
So, using the 4% rule for our explanation, how much do you need to have saved by the time you retire? Answer: Whatever amount your expected spending is 4% of. I’ll do that in an example with numbers in a minute.
3. Savings Target
Now that you have your savings target, you can work backward from there to see how much you need to save each month, year, or whatever interval you plan with.
It’s just like planning for a trip:
- Pick your destination (total savings target)
- Figure out how long you have to get there (how many years until you retire)
- Then calculate how fast you need to drive (how much you need to save)
Here is where you’ll need to make some assumptions. Namely, you’ll need to estimate what you think your investment return will be. Consider how you invest and be reasonable. If you’re a very conservative investor, don’t count on annual returns of 12%. If you are comfortable taking prudent risks with your investments, then you likewise probably don’t need to use a 2% annual return in your calculation. It’s better if you do this calculation several times using different investment returns and base your savings decision on the range of outcomes.
Putting It All Together With An Example
To see a basic example of how this may work, let’s assume you realize that you’ll need to spend $100,000 per year based on your estimated budget. You don’t have a pension, but you estimate your Social Security benefit will cover $36,000 per year. That means you need to withdraw $64,000 per year from your savings. Let’s assume, for illustration’s sake, that you have decided the 4% rule works for you. Since $64,000 is 4% of $1,600,000, then that’s how much you need to save.
Let’s further assume that you are 55, already have $700,000 saved, think you can earn 7% per year on your investments, and plan to retire when you are 65. That leaves you 10 years to save.
In this scenario, you need to save about $15,000 per year to get to $1,600,000 by the time you retire. The math behind this calculation is called the time value of money, or TVM. Don’t worry, you can use an Excel spreadsheet or one of the many calculators available online to do it.
I want to stress this is just a simple illustration to explain a basic process. You need to research some of the concepts discussed here and tailor every step to fit you. You should also update your estimates and plan as you go. However, following this process can help you make sure you stay on track.
