In order to save and invest effectively for retirement, you need a good handle on how big a nest egg you'll have to have. There are various rules of thumb that can help you with that, but take time to estimate carefully, as you may need significantly more -- or less -- than the rules suggest.
Applying the rules
One rule of thumb is to sock away enough to generate about 80% of your pre-retirement income. Here's how you might actually use it.
Imagine that you earn $70,000 per year now, and that you'll want 80% of that, or $56,000, in annual income. If you expect $26,000 in annual income from Social Security, then that leaves $30,000 in needed additional income.
Assume that you subscribe to another widely accepted rule of thumb, that you will most likely be able to make your money last through your retirement if you withdraw 4% from your nest egg in your first year of retirement, and then adjust withdrawals for inflation after that. If $30,000 is 4% of your necessary nest egg, then multiply it by 25 to find out what 100% of the nest egg is. The answer: You'll need to retire with a nest egg of $750,000.
But will you? You might actually need more (or less).
Why you might need more money in retirement
There are a host of reasons why a fatter nest egg might serve you better in retirement. Let's review a few of them:
- Social Security might pay you less than you expect. The average Social Security retirement benefit was recently $1,338 per month, or about $16,000 per year. You can get a much clearer estimate of what you can expect from the horse's mouth, at the Social Security Administration website.
- Healthcare may cost you much more than you expect. According to Fidelity Investments, a 65-year-old couple retiring today will spend, on average, a total of $245,000 out of pocket on healthcare. (That's an average, of course -- meaning you might spend less, or more.)
- Interest rates are low, and won't be high anytime soon. Low interest rates are great in many ways, but they stink for savers who have socked away significant sums for their futures. Any money you stashed away in recent years in bank accounts or CDs, and many bonds, have likely lost purchasing power due to inflation. Low interest rates will get you less bang for your buck when buying annuities, too.
- Speaking of inflation, if it's above average during your retirement, it will shrink your money's purchasing power faster than expected. Inflation has averaged about 3% annually over long periods, but it can go much higher. Social Security payments, fortunately, are adjusted for inflation, and some other income streams, such as dividend payments, are likely to keep pace with or exceed inflation.
- You may live an extraordinarily long time. That's great in many respects, but it can cost you more in healthcare expenses, and can increase your chance of running out of money before running out of breath. Life expectancies have increased in recent decades, making an extra-long life more likely for many of us.
- Finally, consider your particular situation. If you think you'll be supporting grown children or your grandchildren significantly in the future, you may need a bigger nest egg. If you aim to take flying lessons in retirement, or are considering some other pricey pastime, then you might need more, too.
On the other hand...
Of course, there are reasons why you might need less moola in retirement, too. Your retirement lifestyle might be rather inexpensive, with your home paid for, your taxes low, your health generally good, and your hobbies and interests inexpensive (local hiking, reading books from the library, etc.). You might also have a pension to look forward to, or generous offspring planning to at least partly support you.
You can't know exactly how much money you'll need in retirement, but it's smart to spend a little time coming up with the best estimate you can, and then planning for how you'll get there. Don't leave your future up to chance -- and just Social Security.