Retirement planning gimmicks are everywhere. Turn on the TV, read a magazine, or search the internet, there are an endless numbers of calculators, estimators, and “expert” advice.
The truth is, as the burden of retirement savings has shifted from employers to the workers themselves, investors need quantifiable answers to some difficult questions.
How much money do I need to save for retirement?
Much of financial planning exists to answer this one question. So let’s strip away the gimmicks and look at how you can find an answer.
Here’s a simple three step process to setting a retirement savings target.
Think about your retirement income needs.
A little common sense goes a long way in retirement planning. Look at how much money you currently need each month – studies and experience tell us that your future cash flow needs are often not dissimilar to pre-retirement cash flow needs.
Various studies have suggested that you may need 80% of your current monthly income in retirement. Is 80% a perfect number? Absolutely not, but it’s a great place to start for planning purposes. If you’d like to be a bit more conservative then use 90% of your current monthly income.
For this example let’s say you’ve looked it over and expect that $4,000 per month is a reasonable estimate for needed monthly income in retirement.
Define you income sources.
The next step is finding out where that income will come from.
No two retirement income plans are the same, but the principles of building retirement income is timeless. (Click here for our recent article on the principles of retirement income planning)
Build up to your required monthly amount from guaranteed sources, including social security, pension income, etc. Once you come up with a total from guaranteed sources of income, you need to consider your retirement savings.
For instance, let’s say you’ve determined you need $4,000 per month in retirement and Social Security/pensions can provide $3,000 per month. That means you’ll need to utilize your retirement savings for the last $1,000 per month.
Use your income needs to determine your savings target.
There is no magic percentage for a sustainable withdrawal that keeps your principle intact forever. It is a function of your risk tolerance and investment decisions. But for a general rule of thumb, we still abide by the classic 4% rule of sustainable withdrawals.
So let’s discover how much in retirement savings we will need to generate $1,000 per month.
First, we need to turn the monthly figure into a yearly withdrawal amount of $12,000.
($1,000 per month * 12 months)
Then we reverse engineer the yearly income with your sustainable withdrawal rate.
If you work out that math, you’ll see that to generate your needed $1,000 per month in retirement in perpetuity, a reasonable savings target is $300,000.
To some this exercise might bring relief, while bringing stress to others. If you’re in the latter, I would encourage you by reminding you that we are using very conservative estimates, and that any amount of saving you can accomplish before retirement will go a long way.