The average baby boomer says the ideal age to retire is 62, according to a recent Bankrate survey. However, wanting to retire and being financially ready to retire are two completely different things.
The ability to retire comfortably is all about creating enough income to cover your living expenses for the rest of your life. So, before you can say that you're ready to retire, you'll need to know how much income you'll require, where it will come from, and how much you should have in savings.
How much retirement income will you need?
How much money do you need to save before you retire? The most common answer given by Americans is $1 million, while $2 million is the second-most popular savings goal. However, there's a lot more to retire planning than reaching a savings target.
Here's the first thing you need to know. Being able to retire in comfort isn't all about how much money you have saved. Rather, it's about whether you can generate enough income to cover your expenses throughout a decades-long retirement.
Think of it this way. If you need $4,000 per month to lead a comfortable lifestyle, and you get $1,600 per month from Social Security and $2,400 per month from a pension, then it doesn't really matter how much you have in the bank; your income needs will be met regardless. On the other hand, if you need $4,000 per month but your only source of steady income is your $1,600 Social Security benefit, then you'll need a substantial nest egg to bridge the gap.
So how much income will you need in retirement? As with most financial questions, there is no one-size-fits-all answer, but there's a good rule of thumb that you can modify according to your individual circumstances.
The 80% rule
That rule of thumb is that you'll need about 80% of your pre-retirement income to maintain the same quality of life after you retire.
You may be wondering why it wouldn't take 100% of your pre-retirement income to afford the same lifestyle. Well, the 80% rule assumes that, while most of your living expenses will be roughly the same in retirement, two major expenses will disappear when you leave the workforce:
- Retirement savings. The 80% rule assumes that workers funnel 10% of their income into retirement accounts until they quit working for good.
- Job-related expenses such as transportation, dry cleaning, and supplies that aren't provided by your employer.
Every person's situation is different, so we can adjust the 80% rule to fit your individual circumstances. For example, if you currently save 15% of your income for retirement, then that's an extra 5% of your pre-retirement income you won't need.
Similarly, if there are other expenses that you won't have after retirement, those can be subtracted from your retirement income need as well. Maybe you've planned your mortgage so that it will be completely paid off when you retire. If so, you won't have to worry about your housing payment.
In addition, keep in mind that the 80% rule assumes you want to maintain the same lifestyle, so any deviation from this can modify your income need as well. If you plan to live a frugal life in retirement, then you may be able to get by on significantly less money. On the other hand, if you plan on traveling the world, spoiling your grandkids, or taking up an expensive hobby or two, then you may want to plan for that in your income estimates.
I'll walk you through an example of a full retirement needs analysis later on, but for now it's best to start thinking about how much of your current income you'll need to replace to retire with the lifestyle you want.
How much can you expect from Social Security?
Virtually every American senior citizen receives Social Security benefits, so we'll discuss this source of retirement income first. A key step in determining whether you're ready to retire is figuring out how much income you can expect from Social Security.
If you aren't familiar, here's a quick rundown of how the Social Security benefits formula works.
First, the income you earned during each working year of your life, up to the maximum amount that's subject to payroll tax, is adjusted for inflation. Then, the inflation-adjusted income of your 35 highest-earning years is averaged together and divided by 12 to produce your average indexed monthly earnings, or AIME. If you worked less than 35 years total, then a zero will be factored into the average for every year you're short of 35.
Your AIME is then applied to a formula to determine your initial monthly retirement benefit if you claim Social Security at your full retirement age. If you were born in 1954 or earlier, your full retirement age is 66. If you were born in 1960 or later, your full retirement age is 67. If you were born in 1955 through 1959, your full retirement age is somewhere in between.
Regardless of when you choose to start receiving Social Security retirement benefits, your full retirement benefit, or the benefit you'd be entitled to at your full retirement age (also known as your primary insurance amount, or PIA) will be calculated using the formula that was in use during the year you first became eligible for benefits. In other words, for a completely accurate calculation, you'll want to use the Social Security formula from the year you turned 62.
You can find historical Social Security formula information on the SSA's website. In previous years, the formula has worked the same as it does today, but the two monthly income thresholds in the formula (known as "bend points") are different. Here's the 2018 formula; to calculate your PIA, you'll just want to swap out the two bend points as appropriate.
If you turn 62 in 2018, your initial Social Security benefit at full retirement age is the sum of:
- 90% of the first $885 in AIME
- 32% of the amount greater than $885 but less than $5,397
- 15% of the amount greater than $5,397
Unless you claim Social Security at 62, your PIA will be adjusted upward based on annual Social Security cost-of-living adjustments, or COLAs, for each year until you choose to take benefits. In addition, any earnings after the year you turn 62 can also be factored into the AIME calculation and can potentially increase your primary insurance amount even further. The Social Security Administration has a great example if this all sounds confusing.
Finally, if you decide to claim Social Security before or after your full retirement age, your benefit will be permanently lowered or increased as a result. Specifically, here are the three rules the SSA uses:
- If you claim Social Security before reaching full retirement age, your benefit will be permanently reduced at a rate of 6 and 2/3% for each year that you're (about 0.56% per month), up to 36 months early.
- Beyond 36 months before your full retirement age, your benefit is further reduced by 5% per year (about 0.42% per month), as far back as age 62.
- If you delay Social Security beyond your full retirement age, your benefit will be permanently increased at a rate of 8% per year (0.67% per month) beyond your full retirement until age 70, when your potential Social Security benefit reaches its maximum.
The best way to estimate your Social Security income, especially if you're getting close to retiring, is to check out your annual Social Security statement. If you haven't done so already, you can create a mySocialSecurity account at www.ssa.gov, where you can easily view your most recent statement and find other important information about Social Security and Medicare.
How much income will you need from your savings?
Once you have a good idea of how much you can expect from Social Security, as well as any other sources of reliable income such as pensions, you can calculate how much income you'll need from your savings.
Take your retirement income need that you calculated earlier and subtract your annual expected income from Social Security, pensions, annuities, and any other reliable income sources. For example, if you determine that you'll need $75,000 in annual retirement income, and you expect Social Security benefits of $25,000 per year with no pensions or other income sources, then you'll need $50,000 in income from your savings to meet your goal.
How long will your savings need to last?
There's no way to know exactly how long you'll live, but you want to over-prepare for longevity. In other words, make sure you don't outlive your money.
Just to give you a few statistics, consider that American men and women have 20% and 32% chances of living to age 90, respectively. For married couples, there's a 72% chance that at least one spouse will live to 85, a 45% chance at least one will live to 90, and an 18% chance that one will make it to 95, according to the Society of Actuaries.
So if you're retiring at age 65 and in reasonably good health, it's smart to assume that your money will need to last for at least 30 years. Planning for even longer is better, and if you retire earlier or later than age 65, you can adjust your assumptions accordingly.
How much money can you safely withdraw from your nest egg?
One common rule used by financial planners is known as the "4% rule of retirement." In simple terms, this rule states that you can withdraw 4% of your retirement savings during your first year of retirement and adjust this amount upward in subsequent years to keep up with inflation. Stick to that plan, and your money has an excellent chance of lasting for a 30-year retirement.
It's important to mention that the 4% rule makes certain assumptions. Specifically, it assumes a 30-year retirement length, so if you plan to retire early, you may need to ensure that your money will last even longer. It also assumes that at least 50% of your portfolio is allocated to stocks, with the remainder in fixed-income investments such as bonds. In other words, if you decide to put your entire nest egg in a savings account, the 4% rule is likely to be inadequate.
While there are some flaws with the 4% rule, it's still a good starting point for determining how much money you can safely withdraw from your savings each year. If you want to be a little more conservative in your assumptions, you can start with a withdrawal rate of 3.5% or even 3%.
Don't forget about inflation
Finally, another often-overlooked step of retirement planning is inflation. In other words, a dollar today will not have the same value in the future, and this needs to be taken into account.
While there's no way to accurately predict future inflation rates, inflation has historically averaged about 3% per year. It's exceptionally important to account for inflation if you're planning to retire many years from now. For the purposes of this discussion, I'll be talking about people who are at or very near retirement age, so I'll ignore inflation in my examples. However, if you're, say, 40 years old, inflation will have a major impact on how much money you'll need set aside for retirement.
Here's why this matters. Let's say that you plan to retire in 20 years and you anticipate that you'll need $1 million in savings, based on the methods discussed in this article. Remember, that's $1 million in today's dollars. Assuming the inflation rate averages 3% over the next 20 years, you'll actually need about $1.8 million if you want to end up with the equivalent of $1 million today.
So, how much savings will you need?
Let's do a step-by-step retirement readiness analysis for a hypothetical married couple. Here's the case.
Let's say Teri and Jerry are both 64 years old, and they earn a combined salary of $100,000 per year. Teri expects Social Security income of $1,800 per month, and Jerry expects $1,500 per month at his full retirement age (66). In addition, Teri expects a $700 monthly pension from a previous employer. Between both spouses, they have $800,000 in retirement savings.
Teri and Jerry both expect to have pretty typical retirement expenses, so the 80% rule says they should anticipate an $80,000 annual income need. They're considering retiring this year but aren't sure if they're quite ready.
First, if Teri and Jerry retire at your current age of 64, their Social Security benefits will be reduced to $1,560 and $1,300, respectively. Combining this with Teri's expected pension income translates to a total of $42,270 in annual income. Subtracting this from their estimated income need tells us that they'll need to withdraw $37,280 per year from retirement savings.
However, the 4% rule says Teri and Jerry can only safely withdraw $32,000 per year from their $800,000 nest egg (not accounting for inflation after year one of retirement). So, in this case, it may be smart for them to delay retirement for a year or two. Their Social Security income will be higher, they will have additional time to add to retirement savings, and their investments will hopefully grow a bit more.
Retiring early? Here's one other thing to consider
If you're planning to retire before age 65, there's another big factor you may need to consider: healthcare. Many people, especially those who retire from public-sector jobs, may be allowed to keep their employee health benefits in retirement. Others, however, are not so fortunate.
While it's possible to claim Social Security retirement benefits as early as age 62, the same cannot be said of Medicare. You'll need to wait until age 65 to start using Medicare benefits, regardless of when you actually retire.
So, if you retire before age 65 and won't be covered by an employer's health plan, you'll need to budget for the cost of buying your own health insurance on top of the other income needs discussed here.
And these costs can be substantial. The average 60-year old can expect to pay around $8,000 annually for a "silver" plan purchased on the healthcare.gov exchanges, while a more comprehensive "gold" plan can be expected to cost closer to $9,500 -- per person.
To be clear, I'm not saying that health insurance costs should necessarily prevent you from retiring early if you can afford to do so. However, this is a significant additional expense that needs to be taken into account.
What if you're not ready to retire?
The obvious answer is that if you're not ready to retire, or if you rate your retirement readiness as "borderline," then it's probably a good idea to wait. An extra year or two of retirement account contributions and compound interest can make more of a difference than you may think.
Additionally, a delay in your retirement could have a double benefit when it comes to Social Security, earning you delay-retirement credits and potentially boosting your AIME as well.
It's also important to mention that if you want to retire as soon as possible, you can take advantage of catch-up contributions to your retirement accounts after you turn 50. This means that you can contribute as much as $6,500 to an IRA in 2018, and you can defer up to $24,500 of your compensation into a qualified plan such as a 401(k).
The bottom line is that even if you're not completely ready to retire, the methods discussed here can give you a good idea of where you stand and help you figure out how far away you are from being ready to retire.
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