This article was originally published on Sept. 8, 2015. It was updated on Jan. 14, 2016.
Here's a scary statistic: According to the 2015 Retirement Confidence Survey, only 48% of Americans surveyed (or their spouses) have taken the time to estimate how much money they need to sock away for retirement. That's scary, because if you have no idea how much money you need to save for a comfy retirement, then you're not likely to achieve that comfy retirement.
Among those who have pondered the question in order to come up with a plan, many ask themselves, "How much money do I need in the bank in order to live off the interest?" It's smart to broaden that question, asking instead, "How big should my nest egg be in order to provide sufficient income in retirement?" This expands your field of investments beyond bank accounts to investment accounts, brokerage accounts, retirement accounts, and so on.
How much income will you need?
It's hard to estimate how much retirement savings you need to accumulate without first deciding how much income you'll need in retirement. There are various rules of thumb. One suggests that you aim for 80% of your pre-retirement income -- so if you earn $50,000 annually, you'd aim for an income of $40,000 in retirement.
That's a bit simplistic, though, as there are many variables to consider, and each of us is in a different situation. For example, healthier people will likely need to spend less on healthcare in retirement than those with medical challenges, and those who want to travel a lot or enjoy many meals at restaurants will probably need to spend more than stay-at-home retirees. Your retirement spending will change over time, too. Spending can be higher in your early retirement years, when you're doing the traveling that you had put off and perhaps engaging in a lot of recreation, such as golf. Spending may taper off as you get older and stay at home more, perhaps engaging in fewer activities. Then, in your later retirement years, health issues might require you to ramp up your spending. Even these possibilities are general, though, and might not work this way for you.
Your best bet is to do your own math and come up with your own estimate of how much income you'll need each year in retirement, on average. Factor in your health, travel plans, and costly hobbies and interests, along with the usual spending suspects of housing, food, transportation, clothing, utilities, insurance, and so on. You may end up needing that 80% of your income just before retirement, but plenty of people get by on just 50% -- and some people need 100% to maintain the lifestyle they prefer.
How big a nest egg will you need?
Once you know how much income you're aiming for, start figuring out where it will come from. As of January 2016, the average Social Security benefit was $1,341 per month, or about $16,000 per year, but you can expect to collect more or less than that depending on your earning history. (The maximum monthly Social Security benefit for those retiring at their full retirement age in 2016 is $2,788 -- or about $33,500 per year.) If you expect any pension or annuity income, factor that in, too. Whatever gap remains is what you'll need to fund on your own via your investment accounts.
A rough rule of thumb is that when it comes to withdrawing money from a stock-and-bond nest egg each year in retirement, you should aim to withdraw 4% in the first year and then adjust that sum for inflation in following years. This "4% rule" is meant to make your money last for at least 25 years -- though some suggest you should start at 3.5% to be more conservative. If you know you're looking for $20,000 from your investments, then you can inverse the 4% and get 25 (100% divided by 4% is 25). Multiply $20,000 by 25, and you'll arrive at $500,000 -- the nest egg you'll need if you want to apply the 4% rule.
You can use similar math with a bank account that's paying you a certain interest rate, too. Imagine that you're looking for annual income of $20,000 from a bank account that's paying 3% interest. Divide 100 by 3, and you'll get 33.3. Multiply $20,000 by 33.3, and you'll arrive at $666,666 -- the size of the bank account that will give you $20,000 annually with a 3% interest rate. (Remember, of course, that interest rates will fluctuate over time.)
The rules even work with stock portfolios that feature dividend-paying stocks. If you're looking for $20,000 in annual income and your portfolio sports an overall dividend yield of 3%, you'll need that portfolio to be worth around $666,666 come retirement. Of course, that overall 3% yield is likely from a mix of stocks that yield anywhere from 0% to 6% or more. Over the years, you can aim to add more high-quality, high-yielding stocks to your portfolio in order to raise your expected yield. Dividends aren't guaranteed, but many dividend-paying companies are relatively stable and reliable blue chips that have been paying shareholders for decades. These days especially, dividends can reward you more handsomely than interest.
An added benefit of a dividend-heavy stock portfolio over an interest-paying bank account is that, on top of the 2%-3% you'll receive in dividends, the stock itself will likely return 6-7% annually -- which is a growth rate that far exceeds most interest rates paid by banks.
One way or another, most of us will have to supply some of our own retirement income, as we're likely to find Social Security insufficient, and most of us don't have pensions in our futures. Take some time to estimate how much income you'll need -- and how you will get it.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.