We know that people don’t save enough, and deciding to make regular savings is the most important part of any retirement plan. But how do you know if you’re saving enough? Your “number” – the dollar amount that you need to reach in order to safely fund your desired lifestyle in retirement – is an important psychological target to organize your savings and retirement planning around. General targets – say, a million dollars – may sound nice, but to make sure you don’t run out of money in retirement, you’ll need a more solid plan based on your specific needs.
How Much You Need to Save is Dictated by How Much You Want to Withdraw Every Year
Your “number” is the amount of money you need to have accumulated to be able to constantly withdraw from your nest egg in retirement, without depleting it before you die.
How on earth could you possibly know exactly what amount you’ll spend before you die? There are so many variables involved: how long you’ll live, unpredictable expenses such as medical costs, and performance of the stock market, to name a few. The truth is: there’s no way to know your exact number. So you’ll have to make an educated guess with enough wiggle room to keep you covered under the worst of scenarios.
Fortunately, some smart people have already done some of this number-crunching for us. The famous Trinity study in 1998 analyzed the historical performance of several different withdrawal rates from various portfolios of combinations of stocks and bonds over most of the last century, including during the Great Depression, one of the all-time worst-case scenarios. They found that a withdrawal rate of 4% of the initial value of a given portfolio had a 98% chance of lasting at least 30 years – in other words, only a 2% chance of going completely to zero under the worst possible market downturn.
The 4% Rule
The findings of this study created a basic rule of thumb of retirement planning – that you need to be able to save up enough to withdraw 4% of your income every year. Another way of looking at this is that a safe amount is 25 times your desired annual expenses (100% / 4% = 25). In other words, if you save 25 times your desired annual expenses, you should be able to withdraw your annual expenses for at least 30 years without running out of money.
The rule is a good starting point, but there are a couple of glaring problems with the rule.
- It’s based on history – past performance. No math formula in the world can accurately predict what will happen in the future. It could be that the stock market will grow much more slowly over the next several decades than it historically has, which throws all the numbers off.
- Your spending needs to be absolutely constant. The whole thing is predicated on the idea of a fixed, constant withdrawal rate. If you have a year with some wildly large expenses that forced you to dip more into your principal than you planned, it throws the whole thing off.
- Inflation is unpredictable. The diminishing value of money over time is a sure thing, but how much inflation will happen, and at which time points in your retirement, are not sure. Even factoring in regular cost-of-living increases into your withdrawals is no guarantee that inflation won’t rob you of some of your purchasing power. Likely, the value of your invested portfolio will increase at a pace similar to inflation, but that’s not a guarantee
- You might live for a long time. At least until recently, the average life expectancy in the US had been relentlessly increasing. What if today’s 90 is tomorrow’s 100, but you’ve only budgeted to have enough to get you through to 90? Looks like someone’s eating Alpo in retirement.
The Rule Usually Works
Despite all the uncertainty, the rule is there to give you a basic framework to shoot for, and there’s good evidence that it works for people. There are numerous examples of people retiring quite early and riding the 4% safe withdrawal rate indefinitely. Billy and Akaisha Kaderli over at Retire Early Lifestyle retired at age 37 with only $500,000 invested in Vanguard’s S&P 500 index fund, and they’ve actually seen their assets increase while constantly withdrawing an inflation-adjusted 4% of the initial value per year, due to the relentless growth of the stock market on average.
One of you just read that and did a little quick math and said “Nah, I can’t live on $20,000/year”. It’s true, the Kaderlis are pretty frugal and one of the ways they’ve been able to make this work is by spending most of their retirement living in cheaper countries and living with few possessions.
That’s why there’s no single number that’s right for everyone. It’s all up to how much you want to have set aside for your annual spending every year in the future. You can make any amount of spending sustainable in perpetuity with the right “number”, as long as you constantly adjust your lifestyle and spending habits. It’s up to you to decide what you want your lifestyle to be, and save enough to make that happen.
The idea that you need to save enough to fund your desired lifestyle has huge implications for your savings rate. Let’s say you want to give yourself a generous $80,000/year in retirement. Head over to FIRECalc or other online calculators to see how long this will last with various amounts of starting principal. You may be surprised to see that you need several million dollars to make withdrawals of $80k/year last for 30 or more years. Statistically speaking, you’re probably not saving enough to get to millions of dollars before retirement (at least, if you’re a millennial). You’ll need to take a hard look at your savings rate, and if it’s not at least 20% of your income, you should take a hard look at your goals and see if you can increase that savings. If you have any desire to retire early, you’ll probably need a much more aggressive savings rate, say closer to 50%.
The “desired lifestyle” metric runs both ways. Saving millions of dollars is not feasible nor appropriate for everyone. Titrating down your annual spending to match your nest egg is a perfectly fine approach, too, and will be necessary as you readjust your finances in retirement. In the end, your saving and spending behavior is the only thing you have absolute control over. It’s up to you to determine how much of your current income you want to save in order to fund the lifestyle of your choosing for the time period of your choosing. I’d encourage you to play around on FIRECalc to see what different scenarios might look like for you as a way to better inform your current savings decisions.
[Mrs. PW: I grew up believing the Million Dollar Myth, that $1 million is the target number to retire. One million dollars in 1982, when we were born, is equivalent to $2.6 million in 2018. While this myth was true Once Upon a Time, it’s no longer valid today. But the myth hasn’t died, and that’s a problem.]
What is your “number”? How much do you think you’ll want to spend per year? Do you know anyone who has retired early – how are they doing it? Leave your thoughts in the comments below.