It's probably clear to most of us that we need to be socking money away for our retirement. What's less clear, though, is how much we need to save for retirement. Making matters even more complicated is the fact that the answer depends on a bunch of factors, giving each of us a different answer.
First, let's be clear about how important it is to save for retirement. If you're leaving everything to chance, assuming that Social Security will support you and that things will just work out, think again. As of July, the average monthly Social Security benefit was $1,336 per month, or about $16,000 per year. If you earned an above-average wage for most of your life you can expect to collect more than that, but probably not as much as you'd like, by a long shot.
Not enough people seem to realize how critical it is for us to be saving on our own. That's evident by the results of the 2015 Retirement Confidence Survey. It found that 53% of American workers who were asked how much they have saved for retirement and answered have less than $25,000 saved (excluding the value of their home) and 35% have less than $1,000 saved. Yikes.
So what will dictate how much you need to save for retirement? Let's review a bunch of key factors first and then delve into how you might go about estimating what you'll need.
Risk tolerance: If you're very risk-averse, then you'll probably want to be aggressive in your saving. If you can handle some risk, then you'd do well to park your long-term money in the stock market, where it will likely grow faster than in other places. If that makes you uncomfortable, you could stick to "safer" alternatives, but you'll likely earn a much lower rate of return, requiring heftier investments.
Longevity: Few of us know how long we'll live, but if you're very fit and eat well and have many relatives who died in their 90s, you might want to aim for a big nest egg, as you stand a good chance of needing it to support you for a long time. Retiring at 65 and living to 95 means 30 years of retirement! Keep in mind the high cost of healthcare, too, which is unpredictable and can cost at least several thousand dollars per year.
Inflation: It's smart to keep inflation in mind as you estimate how much you'll need, because it can have a powerful effect on your money's purchasing power. If your income is truly fixed and stays so for decades, you may face difficulties in your later years. A Wells Fargo review of retirement risk factors pointed out that between 1990 and 2013, a span of 23 years, the price of a loaf of bread doubled, from $0.68 to $1.39, while the price of a gallon of gas nearly tripled, surging from $1.22 to $3.58. You can't know exactly what inflation will be during your retirement, but know that it has averaged about 3% over long periods.
Crunching the numbers
Keeping the above factors in mind, take a stab at determining how much you'll need to save for retirement. (Online calculators can help with that.) You might follow a common rule of thumb, estimating that you'll want about 70% of the income you earned while working. That makes things easy, but adjust it to better reflect your needs. If you expect to spend a lot on certain categories, such as travel or healthcare or you expect to live a very long life or to face above-average inflation, then ratchet it up.
Once you have a desired income level in mind, start thinking about what it will be made up of. For example, if you're looking for $50,000 in annual retirement income to start, list your known income sources. Perhaps you're expecting $20,000 from Social Security and maybe you're lucky enough to have a pension that will pay another $10,000. If so, then you need to make up the remaining $20,000. (You can get an idea of what to expect from Social Security by signing up for a my Social Security account.)
Another rule of thumb suggests withdrawing 4% from your nest egg in your first year of retirement, and then adjusting that for inflation in each successive year. To find out how big your nest egg will need to be, multiply your desired income, $20,000, by 25, and you'll get the answer: $500,000. If you're very risk averse, you might plan to withdraw just 3% annually, in which case multiply by 33. If you have faith that inflation will remain low and the market will perform well for you, you might plan to withdraw 5% annually, in which case you'd multiply your desired income by just 20, getting $400,000. Be careful taking on extra risk, though, as things don't always work out as hoped.
Building that income
Once you know how much you'll need, think about where it will come from. Give fixed immediate or deferred annuities (but not variable or indexed) some consideration, as they let you buy income streams that can last your lifetime. Healthy, stable, dividend-paying stocks are another great option. If you have, say, $300,000 invested in them with an overall dividend yield of 3.5%, you can look forward to $10,500 annually, while expecting the dividends and the stock prices to rise over time, too.
There's no way to know exactly how much you'll need in retirement, but it's vital to give it some thought and to come up with an educated guess. It's smart to be relatively conservative, too, as life can throw some curves at you.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, 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.