One of the biggest problems with saving for retirement is that you can't be absolutely sure about what experts call your retirement number: the amount of money you'll actually need once you retire. To give you a target you can shoot for, there are simple methods you can use to come up with an estimate of your retirement number. Below, we'll run you through the calculation and give some of the pros and cons of using it over more complex methods.
Your retirement number and the 4% rule
The easiest way to come up with a retirement number estimate is to use what's known as the 4% rule. This method requires two key assumptions:
- You need to figure out how much income you'll need to replace in retirement. That typically requires estimating a percentage of your current compensation from work that you'll still need to cover both necessary living expenses and discretionary purchases once you retire, and then taking into account any retirement income from other sources.
- You'll have to invest in such a way that you can use the retirement-account withdrawal method set out in the 4% rule, namely that you withdraw 4% of your original retirement nest egg the first year of your retirement and then adjust future-year withdrawals for inflation thereafter.
As an example, say that you're within five years of retirement and you make $60,000 annually right now. You estimate that you'll need 80% of your current income to cover retirement expenses, and based on your past earnings history, you expect to receive about $1,500 per month in Social Security benefits.
Using that information, you'd take 80% of $60,000, leaving you with cash needs of $48,000 per year. You'll get $18,000 from Social Security, leaving you with $30,000 left to produce on your own. Divide $30,000 by 4%, and you get $750,000. That's your retirement number.
The pros of using the simple retirement-number calculation method
This simple way of figuring your retirement number has advantages and disadvantages. The best thing about it is that it doesn't take a huge amount of complicated math. Dividing by 4% is the same as multiplying by 25, so the final number represents 25 times your unmet income needs in retirement.
The other major advantage is that the 4% rule has successfully worked in the past to preserve retirement nest eggs for periods of 30 years or more. Even during past times of stock market turmoil, a balanced investment split between stocks and bonds has delivered solid enough returns to make it through tough conditions and still have money left for future years.
Concerns to watch out for using the method
However, there are some potential problems with this simple retirement-number calculation strategy. First, it can be difficult to estimate the numbers to put into the formula. It's impossible to know what your actual expenses will be in retirement. Although using simple assumptions like a percentage of salary makes a good starting point, all it takes is an unexpected illness or injury to throw those projections into question. Similarly, even though you can work from projections of how much Social Security you'll be entitled to receive, the actual amount will depend on your full work history and when you claim benefits.
Similarly, the 4% rule isn't guaranteed to continue to work as a viable retirement withdrawal strategy. Savvy investors can point out that unprecedented low bond rates could jeopardize the ability of the 4% rule to generate safe withdrawals from a retirement nest egg, and the potential for capital losses in a bond portfolio if interest rates rise is a greater risk now than at most times in the past. With many market analysts expecting below-average returns from investments for the foreseeable future, a rule that has worked well in the past might well stop working under current conditions.
Even with these concerns, however, the value of figuring a retirement number is that it can give you a goal to strive toward in your retirement savings efforts. You shouldn't worry about meeting it exactly, but it will serve well as a guideline to see if you're on track to be as financially secure as you want to be.