The biggest pot of money you'll likely ever need will be your retirement nest egg. That money will have to provide for you from the day you stop working until the day you pass away. According to Social Security, an average 65-year-old man will likely live until age 84.3, while an average 65-year-old woman will likely live until age 86.6. About a quarter of all 65-year-olds will live past age 90.
That's about two decades of life after a traditional retirement age -- perhaps even more -- that has to be covered by Social Security, any pension you may receive, and your own investments. With Social Security only covering about 40% of an average retiree's pre-retirement income, you'll need a substantial amount of money to cover the rest of your costs.
Two easy rules of thumb explain why retirement comes first
A decent estimate for the size your retirement portfolio needs to be is known as the 4% rule. By that rule of thumb, you can spend 4% of a well-diversified portfolio balance the first year of your retirement, increase your distribution every year to cover inflation, and be very likely to not run out of money before the end of your retirement. If you follow that guidance, you'll need to retire with about 25 times what your portfolio will need to cover in a typical year in order to have enough.
To wind up with 25 times what you expect to spend in a year, you'll need more than you can simply save under your mattress. Indeed, your money needs time to grow. That's where the second rule of thumb comes in handy, the "Rule of 72." That rule helps you estimate how long it will take your money to double, based on the rate of return you expect from your investments. Divide 72 by your expected investment return, and it will estimate how many years it should take for your money to double.
For instance, if you expect 9% annual returns -- not too far off the stock market's long-term average -- you'd divide 72 by 9 and wind up with about 8 years to double your money. It's not an exact calculation, but it's close enough for a reasonable estimate. If you've got 40 years to work with, that's five doubling periods -- or enough to hopefully turn $1,000 into about $32,000. If you've only got 16 years to work with, that's two doubling periods, or enough to turn that same $1,000 into around $4,000 (hopefully).
Between the 4% Rule and the Rule of 72, two things should be abundantly clear: You need a significant pot of money to retire, and the earlier you get started, the more your money can compound for you.
But what about my house? My kids? A vacation now and then?
Of course, we all have other priorities and goals in life. If you have kids, for instance, you may want to help them get an education without taking on crushing debt burdens. That, too, is a worthwhile life goal. Likewise, there's nothing wrong with saving up to buy a house or taking vacations. As worthy as all those goals may be, it's crucial to create a budget that also has you on track or better when it comes to funding your own retirement (and one in which you have emergency money in short-term savings, so if you don't have money set aside for that, you should get started there first). I would even argue that in many cases, folks should emphasize their retirement savings first before some of these other budget priorities.
Here are three key reasons why budgeting for retirement right now matters:
- You can rent a place to live or borrow to buy a house. You can also take out loans or find creative ways to pay for an education. You can't borrow (aside from perhaps a typically very expensive reverse mortgage) to pay for your retirement.
- If you later find that you've over-saved for your retirement needs, you (or your heirs) can always pay off a mortgage loan or student loan with some of that extra retirement cash.
- As important as vacations can be to recharging and enjoying life, there are ways to travel on a budget. Fit your vacations within the context of an on-track retirement plan, and I think you'll likely find you enjoy them more without the financial headache that overspending generally creates.
Start with your retirement -- then cover your other priorities
Once your retirement plan is on track, you gain the opportunity to turn your focus to your other financial priorities. As you do, you'll likely find that putting your retirement first gave you two huge advantages over those who don't: a lot more freedom on how to approach those other priorities, and the ability to approach them from a position of financial strength rather than worry.
Take those two advantages and add them to the reality that your retirement is the largest expense you can't easily finance, and you wind up with a clear case that many people should strongly consider funding their retirement first.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.