Many of us have the same ultimate financial goal: to amass enough money to leave the workforce for good and live on our own terms. The only problem is that we don't know how much money that takes. There's no way to know exactly how much money you'll need in retirement, but you can at least arrive at a ballpark idea.
If you haven't given the topic much thought and have simply been hoping for the best, you're not alone. In the Employee Benefit Research Institute's 2015 Retirement Confidence Survey, only 48% of respondents (or their spouses) said they had taken the time to estimate how much money they need to save for retirement. That doesn't bode well for many Americans, because it's hard to accumulate enough money when you have no idea what enough is.
It helps to break that number down a bit. Instead of focusing on how big of a nest egg you need, think about how much income you will need or want in retirement and then figure out how you will generate that income through your savings and other income streams.
How much income will you need?
There are many rules of thumb when it comes to how much income you'll need in retirement. One suggests that you aim for 80% of your pre-retirement income -- e.g., if you earn $70,000 annually, then you should aim for annual income of $56,000 in retirement.
There's no one-size-fits-all answer, though, as there are many variables to consider, and we're not all in similar circumstances. For example, healthier people will likely need to spend less on healthcare in retirement than those with medical challenges, while those who want to travel the world or play a lot of golf will probably need to spend more than stay-at-home retirees.
Your spending in retirement will change over time, too. Your spending may be higher in your early retirement years, when you're traveling or going out to dinner a lot. It can then taper off as you get older and start to take it easier. In your later retirement years, your spending may pick up again due to health issues. Even this progression is a generalization, though, and your particular life's spending trends might be quite different.
Your best bet is to do the math for yourself. Factor in your health, travel plans, and costly hobbies and interests, along with the usual spending suspects -- housing, food, transportation, clothing, utilities, insurance, and so on. You may end up needing 80% of your working income in retirement, or you may need 50% or 100%.
How much do you need to accumulate?
Once you know how much income you're aiming for, it's time to start figuring out where it will come from. As of September 2015, the average Social Security benefit was $1,338 per month, or about $16,000 per year. If you earned more than the average American worker over your working life, then you can expect more than that -- and vice versa. To get a much better idea of how much you might expect, set up a my Social Security account.
Once you know how much income you need in retirement and how much of that is likely to come from Social Security -- and perhaps a pension or annuity, too -- then you will know how much you'll need to fund on your own with your investment accounts.
One rough but helpful guideline is that when it comes to withdrawing money from a stock-and-bond nest egg each year in retirement, you should aim to withdraw 4% in the first year and then adjust that sum for inflation in following years. This "4% rule" will likely let your money last about 30 years (though some recommend using a more conservative 3.5% withdrawal rate). For example, if you're looking for $20,000 from your investments, here's how you can determine how big of a nest egg will generate that: Inverse the 4% and get 25 (100% divided by 4% is 25). Multiply $20,000 by 25, and you'll arrive at $500,000, the approximate nest egg you'll need if you want to apply the 4% rule.
You might, if you're able, aim to generate much of your income from dividends or interest alone, leaving your portfolio's value or your principal largely intact. If you're looking for $20,000 in annual income and your portfolio sports an overall dividend yield of 3%, then you'll need that portfolio to be worth around $667,000 come retirement. (To arrive at that, divide 100% by 3%, which gives you 33.3. Multiply $20,000 by 33.3, and you get $666,666.) One of the great things about dividends is that those paid by healthy, growing companies tend to be raised over time. Your overall portfolio's yield may be 3% now, but a decade from now, you could be collecting twice as much in dividend income if your dividends grow at an annual average of 8%.
You can fine-tune your portfolio over the years, too, adding more high-quality, high-yielding stocks to your portfolio in order to increase your expected yield. Remember to consider those stocks with dividends that aren't huge right now but that have been increased significantly over time. A fat but slow-growing dividend can be eclipsed by a smaller, but faster-growing one.
Some investors prefer the "safer" interest from bonds (especially those backed by the U.S. government) or even from bank CDs. Dividends aren't guaranteed, but many dividend-paying companies are relatively stable blue chips that have been paying shareholders for decades. These days especially, dividends can reward you more handsomely than interest.
Annuities are another income-generating possibility. Variable and indexed annuities can be problematic, as many sport steep fees or restrictive terms, while immediate annuities or deferred annuities with fixed payouts (or ones that are adjusted to keep up with inflation) are generally a much better deal. You fork over a large sum to an insurance company, and in return you receive monthly payouts for the rest of your life. As an example, in our current interest rate-environment, a 65-year-old man might pay $100,000 for monthly checks of about $563 -- or $6,756 per year. This is a great way to get guaranteed income, though it's not cheap. It's also only guaranteed so long as the insurer remains solvent, so it's best to seek the strongest companies.
Social Security income alone is not nearly enough to support the kind of retirement lifestyle most Americans want. Thus it's important to plan how you will generate the income streams you need. Planning, saving, and investing effectively now can make your retirement comfortable and secure.
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.