No matter what lifestyle you plan in retirement, preparing for it is never simple. Those who don't put off planning altogether often look for simplified rules to follow instead. But these rules can give you a false sense of security about how prepared you are, causing you to come up short in your later years. Here are three of these rules you shouldn't rely upon -- and how to come up with an accurate retirement plan instead.
1. You need $1 million for retirement
For decades, $1 million was the benchmark for retirement savings, but most of today's workers will find that isn't enough. Back when this rule was widely touted, many workers could also rely on a pension from their jobs, and they weren't living as long. So their money didn't have to last for as many years.
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Today, it's not unreasonable to think your retirement might last 30 years or more, and inflation continues to drive up the cost of living. The Bureau of Labor Statistics estimates that the average household headed by an adult 65 or older spends nearly $50,000 per year today. If we assume a 30-year retirement, that comes out to $1.5 million before we even consider inflation. At 3% per year for inflation, that brings our total to nearly $2.4 million.
2. The 4% retirement withdrawal rule
This rule states that you can safely withdraw 4% of your retirement savings in your first year of retirement. Then, for every subsequent year, you increase this amount slightly to counter inflation. But there are a few problems with this.
First, it's inflexible and doesn't account for the spending changes that many retirees go through. In your early years of retirement, you might be spending more on hobbies and travel, and then as you age, these costs decrease. The 4% rule isn't able to account for increased spending early on. It also doesn't factor in changing market conditions. When markets are down, you might be better off withdrawing a little less; when they're good, you can safely withdraw a little more.
There are other ways to calculate a safe withdrawal strategy in retirement, including one based on your required minimum distributions (RMDs). This also limits your withdrawals in the early years of your retirement, but you can counter this somewhat by also spending any earned interest on your retirement savings each year. Another approach is just to plan for greater spending in the early years of retirement. Figure out how much you need to cover your basic living expenses, and then add a cushion to cover items on your want list, like travel.
3. You'll spend 70% to 80% of your pre-retirement income in retirement
Many retirees spend less in retirement than they did in their working years, so it's possible that you do only end up needing 70% to 80% of your pre-retirement income to cover your retirement expenses. But you can't bank on that, especially if you plan to travel or make big-ticket purchases early in retirement. It's possible you could end up spending just as much or more as you were in your working years.
How to create an accurate retirement plan
To avoid running out of money, you have to create a custom retirement plan based on your anticipated annual spending. Start by estimating the length of your retirement. Subtract your preferred retirement age from your estimated life expectancy and figure high to be safe. Be prepared to adjust your retirement age if you find you're unable to save enough to make your chosen age feasible.
Next, estimate your annual retirement expenses, including food, housing, healthcare, insurance, and entertainment. Multiply this amount by the number of years of your retirement, adding 3% annually for inflation. You can use a retirement calculator if you don't want to do all this math. It'll also estimate your annual investment rate of return (use 5% to 6% to be conservative). Then, it should tell you the total amount you need to save overall and per month to hit your goal. Add a little extra to this if you intend to spend more in the early years of your retirement.
Subtract from these totals any money you expect from another source, like a pension, Social Security, or a 401(k) match. You can estimate your Social Security benefit by creating a my Social Security account. The remainder is what you have to save on your own.
Try to save at least this much each month and make adjustments to your budget if need be. Cut your discretionary spending and look for ways to boost your income, like starting an extra job or pursuing promotions. If you still can't hit your goal, consider readjusting your retirement plan by putting off retirement or delaying your Social Security benefits.
Retirement rules sound great in theory, but they usually don't hold up well in practice. Creating a custom plan lets you know that you're on track for the retirement you want instead of just guessing.
