One of the most important financial questions most of us face in our lives is how much to save for retirement.
Is $250,000 enough? What about $500,000? Or should we strive for something higher -- say, $1 million?
While your answer will differ from mine, the way we both figure it out should roughly follow the same three-step process.
Step 1: Estimating expenses in retirement
The first thing you need to figure out is how much you're likely to spend each year after leaving the workforce.
It's tempting to think your expenses will drop precipitously after you retire. You'll no longer have the costs of commuting to work, eating out with colleagues from the office, or buying work-appropriate attire.
But it's important to remember that you'll also have more leisure time. You'll be able to go to movies on a weeknight, play tennis or golf any day of the week, or take up any number of other hobbies, most of which cost money to pursue.
Retirement experts therefore generally agree that the average retiree will need about 70% of annual pre-retirement income to avoid scaling back his or her lifestyle. Thus, given that the median household income among U.S. workers is about $52,000 per year, according to the U.S. Census Bureau, this means a typical American will need an annual after-tax income of $36,400 in retirement.
Step 2: Accounting for Social Security benefits
Now that we've determined how much you'll need in annual retirement income, the next step is to figure out how much of that amount Social Security benefits will take care of.
Social Security was never meant to be a person's sole source of income in retirement. Its purpose is merely to supplement your own retirement savings. Generally speaking, your benefits will replace between 20% and 50% of your pre-retirement income, depending on your inflation-adjusted average monthly earnings. The more you earned during your lifetime, the less Social Security will replace.
As of March, the average retired worker received $1,332 per month in Social Security retirement benefits. That equates to $15,984 on an annual basis, or roughly 30% of the typical American's pre-retirement earnings.
Subtract the average annual Social Security benefits from $36,400, and the typical American needs to put aside enough during his or her working years to replace approximately $20,400 in annual income.
Step 3: Coming up with your "retirement number"
The final step is to translate the latter figure into your "retirement number." This is the single, all-encompassing amount you'll need to save before retiring to ensure that, after accounting for Social Security benefits, you can replace 70% of your pre-retirement income.
To do this, we use the 4% rule. This is a rule of thumb holding that if you withdraw 4% (or 1/25) of your savings in your first year in retirement and adjust that amount for inflation each subsequent year, then your nest egg should last for three decades, if not longer.
If you work backward, this means that your all-encompassing retirement number equals 25 times the yearly income that you, as opposed to the Social Security system, are responsible for replacing.
The typical American will therefore need to save $510,000 (25 times $20,400) to maintain a pre-retirement lifestyle throughout his or her golden years.
Building in a margin of safety
Before chiseling a number like this into stone, it's important to keep a few things in mind.
The first is that this figure is based on general rules of thumb, such as the 4% rule, that were conceived years ago, when interest rates were higher than they are today. As a result, it's smart to be conservative when settling on your final retirement number.
Along these same lines, we know that medical expenses, which account for an outsized portion of a retiree's costs, are rising faster than inflation. This, too, speaks to the importance of approaching your retirement number conservatively.
Finally, thanks to recent financial setbacks such as the crisis of 2008-2009, many retirees today are entering their golden years with more debt than previous generations. In 1992, fewer than 20% of American retirees still owed money on their mortgages. Today, that figure is 40%.
The point is that exercises like this are necessary to plan ahead for life after work. But given the critical importance of saving for retirement, one should approach the process with humility by factoring in a comfortable margin of safety.