How Much Do I Need to Retire?
Written by: Nicole Gobel, CPA
“How much do I need to retire?” is possibly the most important question that an advisor can help answer for a client. While the answer is different for every situation there are essential pieces of information that should always be part of the conversation. Some are factual, while others are assumptions that represent the best guess at future conditions in the economy or financial markets.
These include:
- What is the cash flow needed for my desired lifestyle?
- How much will be funded from retirement savings vs. other sources of income?
- What assumptions should I use for long-term inflation, investment returns and a distribution rate for my portfolio?
Retirement Income Needs
As a general rule, most consider 80% of your pre-retirement income to be an adequate target. To determine what percentage is appropriate for you, consider what expenses may be eliminated during retirement including the cost of commuting and the amount you have been saving toward retirement. Will you be downsizing to a single vehicle or smaller home? Will your cost of living be reduced, or state income taxes eliminated due to relocating?
There are also expenses that may increase early in retirement. Most of my clients include a travel budget as a priority in their retirement plans. Spending on other hobbies or charitable causes may also increase with more time to spend on these activities.
Debt is another item to consider. While we do not recommend paying off a low fixed-rate mortgage earlier than necessary, some retirees are in the fortunate position of having already paid off their homes. Car loans or home equity loans are other forms of low-interest rate debt that you can be comfortable carrying while paying off high-interest rate debt like credit cards should be a priority while you are still working. It is also important to consider using debt in retirement when appropriate versus withdrawing large amounts from your retirement accounts for cash purchases and unnecessarily increasing income taxes.
People are also retiring earlier and may still be supporting other family members such as funding college or caring for an elderly parent. Health care costs are another big concern. Individuals who are not yet eligible for Medicare often need to purchase their own insurance coverage for a time and later supplemental policies that can be more expensive than previous employer plans. Some individuals choose to move into continuing care communities that may require an expensive purchase price but then provide access and potential discounts to long-term care services in the future. Long-term care insurance can help protect against these rising costs, but policies can be cost-prohibitive for many.
You should review your current spending, what costs can be reduced or eliminated and what items may increase. Doing research on the cost of living in an area you are considering relocating to or speaking with someone about the estimated cost of health insurance are great ways to better prepare yourself for the transition.
Sources of Cash Flow for Retirement
Once you have an estimate of how much cash flow your desired lifestyle will require the next step is determining what sources to pull from and in what order. Gone are the days of hefty employer pension plans funding the majority of your household spending. Aside from government workers, public educators and those grandfathered into former employer pension plans many individuals transition into retirement with no expectation for non-investment income aside from Social Security benefits.
If you’re lucky enough to be eligible to receive a pension, there are some decisions to be made including timing of receipt and survivor benefits. Some employers provide a lump sum rollover option to an IRA. The advantage can be that you have control of the full amount in advance and invest as you see fit. If either you or both you and your spouse pass prematurely the balance is still preserved for your heirs.
Electing Social Security benefits is also an important decision. I’ve heard many clients say they plan to elect at age 62, however, electing early reduces your benefits by 30% and does not allow you to earn any part-time income in excess of around $20,000. After attaining Full Retirement Age (67 for most) you can take the full benefit regardless of other income. Your benefit grows at 8% per year that you defer so if you expect to live well into your 80’s it is best to defer to age 70. If you are a married couple the surviving spouse only receives the higher of the two benefits while expenses are typically not cut in half. According to Social Security as of June 2021, the average retiree benefit was $18,660 per year.
Annuities are often touted as a good choice, however, in my experience, they are very expensive for what you receive. We often have clients come to us paying over 3% in fees to an insurance company, broker and mutual fund managers without having the knowledge they are doing so and underperforming the overall market.
The final source for retirement income, unless you’re expecting a large inheritance, is your retirement savings. You hopefully have created three buckets to pull from. The first is your tax-deferred savings often comprised of one or more employer retirement plans and a Traditional or Rollover IRA. Each dollar that you withdraw from these accounts unless you have made nondeductible contributions, is taxable at your ordinary income tax rate. Treatment of retirement income varies by state with some allowing you to exclude a certain portion each year while other states don’t tax distributions at all. New York allows each person to exclude $20,000 after age 59 ½. While not everyone needs to pull from these accounts the IRS requires that you begin taking a portion of your account beginning at age 72 called required minimum distributions (RMD).
The second bucket that not all individuals have had the opportunity to build up is tax-free or Roth accounts. These accounts, whether through an employer plan or Roth IRA, were funded with after-tax contributions and the earnings are tax-free. The advantage is any withdrawal later is also tax-free and these accounts are not subject to RMD.
The last bucket is your taxable or after-tax savings. This is typically a combination of cash savings along with one or more brokerage accounts. While distributions from these accounts are not taxable, the interest, dividends and capital gains realized in these accounts each year is taxable.
It is important to consider not only the amount that should be withdrawn from each type of account but also the timing. Earlier we discussed elections around Social Security and pensions and this must be factored in as well. In addition, it is important to understand your total income as you could be subject to higher Medicare premiums unnecessarily without proper planning.
Inflation and Investment Return Assumptions
Inflation over the last 20 years has only averaged 2.18%. This includes our current inflation rate of around 7%. However, when we look back over longer periods from 30 years -100 years, average annual inflation has been anywhere between 2.34% and 3.86%. While some sectors have recently realized significant inflationary pressures such as used cars and energy, other areas have not grown in price as quickly. We do feel that long-term inflation will be higher than what we have seen over the last 20 years, however, choosing an inflation rate that makes sense in your financial plan has to factor in what expenses are subject to this growth and how far into the future your plan extends.
Using a relatively conservative 3% inflation factor for overall costs given the historical data makes sense. If you have a fixed-rate 30-year mortgage you know this cost is not going to increase so you’re protected from inflation for one of your larger outflows. However, there are other expenses that you should factor in higher inflation including education and health care costs. For example, using 6% or higher for these costs makes sense. Another thing to consider is that many pensions are fixed and do not include cost of living increases. While Social Security does have a cost-of-living adjustment it varies annually.
In order to keep up with inflation, you should have a significant amount of your savings invested and growing for your future. On average, the S&P 500 Index has grown close to 10% annually over the long term, where as long-term bond returns have been closer to 5%. That being said, given where interest rates are today it is not a good environment for bonds, and we expect about half of that in the near future. There is also the expectation for potentially lower equity market returns given the three years of outperformance we have experienced.
Read our related article for more information: Should My Investment Allocation Become More Conservative in Retirement?
The ability to back into your total savings number needed to retire must also take into account what distribution rate your accounts can sustain over the long term. The 4% rule was long thought of as being a great standard to live by. Therefore, if you saved $1 million for retirement you could safely withdraw $40,000 your first year without jeopardizing your long-term retirement. Although static, the rule does allow an increase in distributions to adjust for inflation, but some retirees choose to keep their withdrawals the same each year.
Given the assumptions noted above for higher inflation and lower expected returns in the near term, new studies are showing retirees may need to lower their expectations closer to 3%. That being said, many advisors have stated 4% was too conservative and subscribed to more dynamic spending rules such as a range between 4% and 6% each year. We suggest working with your financial advisor to discuss the long-term average return expected from your portfolio to determine what is right for you.
Conclusion
There are many considerations when determining what the magic number is to ensure you can retire and sustain your desired lifestyle. We have discussed some of the most important items, but every client situation is different and should be evaluated individually.
- You must first determine the cash flow needed in retirement.
- Next, calculate what percentage of your desired income will be covered by a pension, Social Security or other reliable income sources.
- Finally, back into the amount you will need to withdraw from retirement savings. Using the 4% rule if you require $40,000 a year you should aim to have $1 million invested. If you need $80,000 supported by distributions, you should aim for double that amount.
We work with our clients to help them through the process of creating a retirement plan to ensure they have a clear picture of what they need to save, when they can retire and whether they can afford the lifestyle they desire. If you have any questions regarding financial planning, please feel free to contact our team for a discussion.
Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.
Sources
Inflation – http://www.officialdata.org
Return data – https://www.forbes.com/advisor/investing/stock-and-bond-returns/
Distribution rates – https://www.forbes.com/advisor/retirement/dynamic-spending-rules/