Retirement is supposed to be a time when you can kick back, relax, and enjoy your hard-earned leisure time. For some people, that means puttering around the house working on new hobbies or spending time with the grandkids. For others, it means taking that big trip across Europe you've been dreaming about for decades.
Nearly half (46%) of households spend more in the first two years of retirement than they did prior to leaving their jobs, according to a study from the Employee Benefit Research Institute. And according to the Bureau of Labor Statistics, the average American age 65 and up spends nearly $46,000 per year -- or around $3,800 per month.
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Spending more during retirement than you did while you were working isn't necessarily a bad thing. After all, you want to be able to enjoy your golden years the best you can, not worry about pinching every penny. But the truth is that most people don't have enough saved to be able to keep up these spending habits.
According to Vanguard's 2018 How America Saves report, the average 401(K) participant age 65 and up has a balance of around $210,000. That may sound like a healthy number, but if you're spending $46,000 per year, that $210,000 will only last around 4.5 years.
You might also have Social Security benefits to cushion your personal savings, but considering the average Social Security check is just $1,300 per month (or $15,600 per year), that money may not go as far as you think. In this scenario, if you're spending $46,000 per year and $15,600 comes from Social Security, a nest egg of $210,000 will last less than seven years.
Building a nest egg that will withstand retirement
There's no hard-and-fast rule for how much you need to save for retirement. You may need $200,000 or you may need $2 million. It all comes down to how much you expect to spend each year. Once you know what you'll need to get by each year, you can work backwards to see how much you'll need to save total before you retire.
Say you're planning on spending $46,000 per year during retirement and you'll be receiving $15,600 per year from Social Security. That leaves $30,400 that will need to come from your own savings. Here's a simple strategy: Multiply that by 25 to see how much you'll need to have saved by the time you retire. $30,400 times 25 is $760,000.
Why multiply by 25? It's based on the 4% rule, an oft-cited guideline that states that if you withdraw 4% of your savings during the first year of retirement, then adjust that number each subsequent year based on inflation, your savings will last around 30 years. So in this case, if you have a nest egg of $760,000, multiply that by 4%, and you can withdraw $30,400 during your first year of retirement.
There are downsides to the 4% rule, however. For one, it's just a general guideline. Say, for example, you retire at 65 and spend 20 years in retirement. Because the 4% rule assumes a 30-year retirement, you could be selling your retirement lifestyle short by saving more than you need. That said, one in four 65-year-olds will live past age 90, according to the Social Security Administration, so if you retire in your early 60s, you may end up needing more than what the 4% rule suggests.
Another potential flaw is that the 4% rule assumes you'll be spending roughly the same amount each year of retirement (adjusting for inflation, of course). But as you age, you may be spending far more on healthcare expenses each year than you did during your early years of retirement -- which could put you at risk of running out of money when you're older. Of course, you can't predict how much you'll pay in healthcare costs, so it's difficult to plan for them. But even if you follow the 4% rule rigidly, unexpected costs could still throw you for a loop.
Making the most of the 4% rule
The best way to take advantage of the 4% rule is to use it as a guideline to see whether you're in the ballpark when it comes to saving for retirement. If the 4% rule says you should have $700,000 saved for retirement and you're only on track to save $200,000, for example, you may have a problem.
You can also tinker with the numbers to see how adjusting the amount you plan to spend each year affects your overall savings goal. For example, say you think you'll need $40,000 per year to cover all your expenses in retirement. Multiply that by 25, and that equates to a nest egg of $1 million. But what if you could cut back on some expenses so that you only need $30,000 per year? In that case, you'd only need to save $750,000.
The 4% rule is also good for seeing how far your current savings will go. For example, $200,000 may seem like a ton of money, but according to the 4% rule, you'd only be able to withdraw $8,000 your first year of retirement. Even with Social Security benefits to supplement your income, it would still be tough to make it by with those savings.
Retirement planning is both an art and a science. While it's never a good idea to wing it and hope for the best, it's also impossible to plan every detail. Oftentimes the best thing you can do is research as much as you can, establish a plan that's as accurate as possible, but then be ready to roll with the punches and adjust that plan throughout your retirement journey.
