How much money do I need to retire?

Begin with the end in mind – that was one of Stephen Covey’s principles for highly effective people. Knowing that final goal post – how much do you need to retire is a very important question to answer. That can help you figure out what you need to do today to help move toward that goal. In the last article, I talked about having income producing assets that can ultimately replace your income to enable you to retire. In this article, we are going to get a bit into the nuts and bolts of how to come up with that number. 

This is simply a framework to get you to a starting point. You do need to go over this in detail with a financial advisor to dig into your own individual circumstances. Finally, this is going to be a longer article than normal, so get yourself a hot drink (or a cold one), relax and read on. 

This is going to involve some numbers and calculations so brace yourself. There are 4 fundamental steps you need to follow to know how much you need for retirement. Lets begin – 

Step 1: Estimate your expenses at retirement

Now, depending on how many years away you think you want to be from retirement, this is going to be difficult or easy. The longer your time horizon, the more difficult this is. What I would suggest is to simply use your current spending as a baseline. Add or subtract some of the below highlighted expenses that you think could change in your retirement. Simply put this in a spreadsheet in today’s dollars and add an estimated annual inflation % for every year until you retire. Financial planners typically suggest using a 3% inflation each year. Some of these expenses can also change during the course of your retirement. So just make your best estimate. You don’t need to go for preciseness here but get as directionally accurate as possible. 

• Children’s expenses: If you have children and are expecting to retire after they head to college (and you have either paid for their education or are expecting them to pay for it), then you can reduce all expenses associated with your children at retirement. Now, depending on the kind of parent you are, and culture you are from, you may choose to want to support your children even after they graduate for a bit. My personal hope is I don’t have to support my children any more after they are done with college. 
• Travel: Normally in the earlier years of retirement, couples tend to travel a lot and so you should budget more for travel. If you are someone who is already traveling a lot then maybe keep it at the same level. Some figure out ways to pay for travel through credit card points. 
• Housing: You may be planning to retire in a fully paid off house or buy a new house in retirement in cash (with the sale proceeds of your fully paid off current house). Then you can eliminate the Principal and Interest portion of your mortgage you pay today. 
• Healthcare: this is probably the biggest and most challenging one to estimate especially if you live in the US. Now, I have made it a personal mission to understand this in detail and I plan on writing a separate, detailed article on this. But understand that if you retire before 65, you will need to buy a healthcare plan in the open market exchanges and can be pretty expensive. Medicare after 65 is not free either because you will still be paying some premiums. If you live in Canada or some other country where healthcare is fully paid for, then this will look very different. 

Step 2: Understand your income sources in retirement

Hold on! Income during retirement? I thought retirement meant I stop working and don’t make any money? Let me explain – when I say income during retirement, I simply mean the income you will be generating through your assets you have built up to retire. Now, you could expect to have a part time job or a side gig that generates income for you during retirement. So consider the following income sources:

• Withdrawal and dividends from retirement vehicles – these include withdrawals from your 401K, IRAs, Roth IRAs etc. These have different names in different countries. 
• Withdrawal from taxable trading accounts – if you have stocks and bonds in your regular trading accounts like Schwab, Robinhood, E-trade etc you can withdraw from that too. 
• Pensions – if you are one of those lucky ones who still has an employer who has a pension plan, you can certainly count on those. 
• Real estate – if you have rental property you plan on having during retirement, you can count on rental income too. (Personal side note: I love the idea of having a fixed rental income during retirement – its a bit of your own personal pension plan)
• Social security – In the US, a lot of folks count on social security because they have been paying into this every single paycheck during their working life. The unfortunate reality is if you are 20+ years away from the age 62 (which is the earliest age you can start withdrawing social security in the US), then you will likely not get 100% of your benefits. This is because the current social security system is under funded and is a bit of a ticking time bomb. If you are only 5-7 years away from withdrawal then you can probably count on getting a 100% of this. I personally don’t factor this because I am 20+ years away from it. 
• Other sources – like i mentioned above, you may be considering other income and you should factor that too. 

Step 3: Estimate how much you need for retirement

After you have completed Steps 1 and 2, we are ready to actually calculate this number. This is where we will need to start crunching some numbers. But first, let’s set this up. 

If you are expecting your income sources as identified in Step 2 to be almost entirely through withdrawals from the market (traditional retirement vehicles or trading accounts), then the following rule of thumb can give you a good starting point. Some of you may have heard of the 4% rule. Before I explain this, please understand this is simply a guide and a starting point. Don’t get swayed by the preciseness of the numbers.  

The 4% rule was first created by William Bengen, a retired financial planner, in his famous article* in 1994 where after a thorough analysis of US stock market returns over a period of 70+ years, concluded that if you want to pretty much never run out of money then you should withdraw no more than 4% of your portfolio for the first year of retirement and then increase or decrease the amount every year after, based on inflation or deflation. He based this on a 50/50 allocation between stocks and bonds. He has since updated this article in 2020 and said this could be 4.5%. If you are planning on an early retirement and have a horizon of 50+ years, then your safest withdrawal rate should be 3.5%** and have a slightly more aggressive portfolio of 60% stocks and 40% bonds. 

So what does that mean? Calculating backward, using the 4% rule,  it simply means you need 25X (1/.04) your annual expenses as a pot of money to withdraw from, every year. So if you estimated your annual expenses would be $100,000 in Step 1, then you need your portfolio to be $100,000*25=$2.5M. If your annual expenses are lower, you will need less money and if they are higher, you will need more money. In year 1 of retirement, you will withdraw $100,000 and then in year 2, assume inflation is 3% so you will then withdraw $103,000 and so on. 

So if you are more curious you probably want to know the logic behind the 4%. Below is the simplistic logic behind it. 

If you stick to this rule, the idea is you will not only not run out of money, you will likely die with a huge chunk of money. 4% is supposed to be the Safe Withdrawal Rate which was calculated based on the worst possible scenario. So it does mean you could withdraw more but your probability of running out of money goes up. There are a few nuances to this that I won’t go into and so you should not be blindly following this but rather, use this as a starting point. This is based on US average stock returns but you can get the data for any international indices and inflation and use this model. 

Now if you have income from non-stock market assets then here is what you do – estimate your annual income from these other sources (rental income, pensions etc) and subtract them from your annual expenses and use the above 4% rule on the difference. For eg. If you estimate roughly $40,000 of annual income from non-stock market sources and your annual expenses are $100,000, then you need to apply the 4% rule on the remaining $60,000. So multiply $60,000 by 25 to get you $1.5M needed in your stock/bond portfolio. 

Step 4: Assess where you are at now

Technically this is a step you could do any time. But in order to know exactly what actions you need to be taking today, you will need to do this step. 

This will need to be an assessment of all your assets and liabilities. I will not go into detail here because I have referenced this in my earlier article “If you can measure it, you can improve it”. 

Financial advisors use tools to then show expected growth rates of your assets over your time horizon and can then give you an idea as to whether you are on track for your retirement or not based on where you are now. You can model all this yourself in a spreadsheet too if you are savvy enough. I would encourage you to be conservative when you estimate growth rates for your investments. You will basically fall into one of these 2 buckets:

1. You are well on track for your retirement goals – you probably have a great savings rate and are appropriately investing your money in income producing assets.Just keep doing what you are doing and you will be fine.  
2. You are not on track for your retirement goals – that may be because you are not saving enough money to invest and/or you are not investing them appropriately. You need to make adjustments to your plan by figuring out how to either increase your savings or picking the right type of investments. 

A good financial advisor will walk you through this and help you make a plan. They should always start off by asking about your retirement goals and help you work backwards. 

Ok hopefully I did not numb you with all the numbers and details. Planning for your retirement can feel overwhelming. My hope was to provide a reasonable framework of steps to plan for this. I wish you success on your journey to financial wellbeing. 

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice. 

*Determining Withdrawal rates using historical data – By William Bengen https://www.retailinvestor.org/pdf/Bengen1.pdf **https://www.kitces.com/blog/the-problem-with-fireing-at-4-and-the-need-for-flexible-spending-rules/#:~:text=In%20fact%2C%20in%20a%201996,a%2045%2Dyear%20time%20horizon.