How Much Do I Need To Retire?
This is the most difficult question to answer…
How Much Do I Need To Retire?
By far the most difficult question, which can lead to many more questions. You can answer this question by looking at the most important factors:
- What is my net worth? (retirement accounts, home equity, outstanding debt and other assets)
- How much I spend a month? (rent, mortgage, car payments, basic living necessities)
- Will I maintain my current lifestyle in retirement?
- Do I have any additional sources of income in retirement? (pension, social security benefits, annuities or drawing down a 401k)
- How much do I need to retire?
What is my net worth?
It is a simple equation, assets minus liabilities equals your overall net worth.
Assets are: cash, investment accounts, 401k retirement plans, the equity balance in your personal residence, real estate, or other property that can be easily turned into cash.
Liabilities are: student loans, outstanding balance on your mortgage, automotive financing, credit card debt, child support or any obligation to repay a lender.
Once you have calculated your net worth, we must determine what is liquid and not liquid. Typically, anything that can be converted to cash within 6 to 12 months is liquid.
Once you have calculated your net worth, we need to compare it to fellow American’s net worth by age.
The average retirement account balance by age during the Federal Reserves 2016 survey indicated most Americans have an average retirement account balance of less than $1 million dollars.
- Less than 35 years old: $32,500
- 35 – 44 years old: $100,100
- 45 to 54 years old: $215,800
- 55 to 64 years old: $374,000
- 65 to 74 years old: $358,400
- 75 and older: $336,500
How much I spend a month?
Add up all your monthly expenses so you can get a better picture of where your money goes and to determine if you will have similar expenses in retirement.
Required expenses: food, rent or mortgage, transportation costs such as a car payment or insurance, medical insurance
Discretionary expenses: entertainment, clothing, cable tv, gym membership, salon expenses, vacation, restaurants, alcohol or Amazon orders.
These are very generic descriptions of expenses you may encounter in your daily life. Start by writing them down or creating an excel file of every dollar that goes out of your bank accounts every month. If you have a checking account with a company such as Bank of America and you purchase most things with your debit card, you can export your transaction history to an excel file. If you use cash for most transactions, the expense analysis is a little more difficult because most people don’t keep receipts from every day life. The goal is to track expenses that occur on a frequent basis and define whether they are a required expense or discretionary.
You need to analyze what is driving the expenses and if they are recurring. A one-time expense such as a car repair isn’t as important to your overall financial picture than the $6-dollar Starbucks drink you purchase every day ($6 * 365 = $2190 a year).
Will I maintain my current lifestyle in retirement?
Most retirees have a reduced income compared to your working years. This means buying a new car every 1-2 years is out of the question for most people. During your working years it is easy to take that weekly pay check for granted because you know there will always be another one, whereas in retirement you might have a quarterly dividend, or monthly social security benefit. The monthly or quarterly sum of money will be larger, but it also means you need to be extremely responsible managing your expenses because you need it to last a month or 3 months.
What is important to you, may not be important to others… Maybe you enjoy golf and having a club membership is important to you, or maybe traveling is a retirement lifestyle goal. If you have a hobby or passion, manage your money so you can pursue it. The goal of retirement isn’t to work for 30 years just so you can stop and do nothing. Retirement allows you to pursue passions with your newly acquired free time.
Do I have any additional sources of income in retirement?
If you are lucky enough to work for an employer or government that offers pension benefits, you don’t need to rely as much on a 401k or other retirement benefits to provide retirement income. The public sector is beginning to become the largest provider of pension benefits and according to the Census, the top 100 public employee pensions systems had $3.8 trillion in assets.
Companies are moving away from pension plans
Employer Defined Benefit plans have been phased out over the past 20 years in favor of defined contribution plans also known as a “401k plan”. The reason for this is years of employee and corporate contributions were not lasting longer than retired employee distributions. Or in other words, Americans started living longer than employers estimated and the pension funds had to pay out more than they collected. For businesses it was tough to digest that paying former employees’ pension benefits was a bigger cost driver than paying current employees.
There are still holdover pension plans which have been “frozen”, meaning they are no longer active for new employees, but will continue paying benefits to current employees. A frozen pension plan offered to a Fortune 500 company’s employees in Orlando, provides $90 annual benefit upon retirement for each year of service to the company.
An example would be if an employee worked 20 years, they would be entitled to $1,800 of pension benefits for the rest of their life. This pension plan was phased out in the late 2000’s and anyone hired after the phase out date is entitled to a defined contribution plan, or 401k plan. The 401k plan is expected to save the company billions in annual contributions, while still offering employees a lucrative 401k match of 50% on 8% of employee 401k contributions.
An example would be if an employee made $100,000 a year salary and contributed 8% of their salary to their 401k. They contributed $8,000 and because the employer does 50% on 8% of employee contributions the employer contributes $4,000. The $4,000 contribution is still less than paying out pension benefits over the lifetime of an employee, so it makes economic sense for companies to offer a 401k over a pension plan.
How to manage a 401k heading into retirement?
Let’s assume you know what a 401k is and you have contributed to one your entire career. You have your lump sum in your 401k and you need to start drawing it down, so you can pay your living expenses. This becomes a delicate balance to make sure the money lasts the duration of your lifetime and not leaving it all for your spoiled kids to inherit. There is an unwritten rule to follow, it’s called the 4% rule. If you withdraw 4% a year, you should have enough annual income to survive while allowing your lump sum to continue making investment income.
When you are retired there are a few investment options to make sure your money lasts:
Invest your lump sum into low risk income producing assets such as bonds, or other fixed income securities. The goal is to protect the initial investment value of your portfolio, while producing a reasonable amount of income.
An example would be investing into a 3-year treasury note that yields 2.4%, or $24,000 a year income on a million dollars invested. You would get $24,000 a year in interest payments, or $12,000 every six months because the interest payment is semiannual. At the end of the 3 years you would receive your $1,000,000 principal back at maturity.
Another example with a little bit more risk but based on the same principles of fixed income investing would be to purchase a fixed income exchange traded fund. One we periodically purchase for clients is the SPDR® Portfolio Short Term Treasury ETF which is listed under the ticker SPTS. The SPTS seeks to mirror the Bloomberg Barclays 1-3 year treasury index. As of 7/2/2019, the ETF pays a 2.16% coupon, or dividend payment to shareholders. The benefit to holding an ETF rather than a bond is you can choose to sell your ETF if you need liquid cash. You would receive monthly dividend payments, or roughly $1,800 a month pretax based on a 2.16% dividend yield.
Purchase an annuity
Annuities could be another investment option in retirement, as they provide fixed payments over the rest of your lifetime. A million-dollar annuity has the potential to pay out between $50,000 to $60,000 because when the insurance company invests your principal they can take additional risk to generate additional return. The insurance company has a going concern, meaning they expect to be in business for many years and will far outlive you. This going concern allows the insurance company to take risks that will make the principal rate of return outperform their annual payment to you.
The only way you beat the insurance company is if you purchase an annuity before a market crash and the insurance company has to continue paying out even though the investment assets your payments are based have declined in value.
The major downside is you need sacrifice the lump sum of money to an insurance agency to receive the fixed payments. A large sum of money has tremendous compounding power, meaning it doesn’t take as many periods or years to turn your money into an even larger sum. Insurance companies know this and they use the compounding effect to make a significant profit on your annuity.
I do not recommend annuities to clients because in most market conditions you can draw down your lump sum at a rate of 3% – 4%, while also investing your money to make a 3% – 5% annual return on the remainder portfolio value with a conservative portfolio. If you are diligent in your retirement lifestyle, you will not outlive your money and may have something to give to your heirs.
It’s a government benefit/retirement system that you pay into, that will pay you a monthly check upon you reaching eligible retirement age. It’s similar to a pension; however, you must pay FICA tax for most of your working career to be eligible for a benefit. The Social Security Administration has tools on their website to estimate what your retirement benefit will be, I have attached a hyperlinked image below for you to use the tool and estimate your benefit.
You can elect to take social security between ages 62 and 70, the longer you wait the bigger your monthly benefit will be. Full retirement age is dependent upon your birthday, if you were born after 1960 your full retirement age is 67. Assuming you were born after 1960, if you take your benefits at 62 you will only be eligible for 70% of your benefits, whereas if you wait until full retirement age of 67 you will 100% of your social security benefits. You can calculate their benefits based on lifetime earnings on the social security website but based on the common working American you can assume you will have between $2,000 to $4,000 when you claim your social security benefits. Social Security wasn’t designed to be a primary retirement plan, it is meant to supplement your other income sources while protecting most Americans from themselves. Since only ½ Americans participate in a 401k and employers are no longer offering a pension plan, social security is a failsafe for some.
How much do I need to retire?
What your sources of retirement income will be depend on your profession, your lifestyle and how diligent you save during your working years. We believe you need between 70% to 80% of your pre-retirement income to live a similar lifestyle as during your working years. The income sources can be from social security, 401k, pension or other retirement vehicle.
If you make a $100,000 salary the year before you retire, you need between $70,000 to $80,000 of retirement income to manage a similar lifestyle. Assuming you receive between $24,000 to $44,000 in Social Security income, you have a $36,000 to $45,000 income shortfall that needs to be made up from other sources.
To make up this shortfall with only a 401k, you need between $900,000 to $1,200,000 million to produce between $36,000 to $45,000 in annual income while taking minimum risk. If you have a pension, you may earn an additional $1,000 to $3,000 depending on your specific plan and years of service. Between social security and a pension, you may not need a large balance in a 401k to live comfortably.
This leads to why having a fee-based financial professional prepare a financial plan is tremendously important, there are too many factors to consider and look at objectively by yourself. A fee-only financial professional can prepare a financial plan analyzing all the factors I wrote about, while maintaining fiduciary duty to look out for your best interest.
Thinking about Retirement?
Learn more about how we manage client retirement accounts with Interactive Brokers