I did an informal survey of physicians back in 2016. One of the questions I asked was this: How much do you need for retirement? 11% of the nearly 1000 physicians said they had no idea. This is a problem. How do you attain a goal if you can not define it? So let’s try to do that here.
Annual Expenditure in Retirement
Going about finding how much of a nest egg you need starts with figuring out what your annual expenditure in retirement will be. Barring very early retirees, for whom things might look slightly different, this calculation is not as daunting as it may seem.
- If your house is paid off (and hopefully it will be!), include real estate taxes, HOA dues, utility bills and maintenance costs. Budget about $1 per square foot or 1% of home value as annual (un)expected home repair costs. More for older homes with extremes of temperature or humidity.
- Healthcare Costs: This is the biggie. And with the swings in direction healthcare is going in this country, more of a pain to estimate. That is why I dedicated a couple of posts to it: HealthCare Costs in Retirement.
Once you reach Medicare age, 65 years at this time- average costs are [Medicare + Supplemental Plan] premiums + cost sharing (deductibles/copays/coinsurance) + anything not covered by Medicare (Dental, vision and hearing).
Before you reach Medicare age, an estimate of healthcare costs would be Annual Premiums + Out-of-pocket maximum. You would hopefully not reach OOP max every year, but for budgeting purposes, you have to consider it as such.
The elephant in the room, though, is long term care. This is usually required towards the end of retirement and may run into hundreds of thousands. But nearly 50% of retirees do not incur any long term care costs. Hence it is difficult to state an average and plan for it. Worst care scenario- live down retirement and go on Medicaid.
- Staples like food and clothing will make up some part of the number but not a big part.
- Helping with kids’ higher education: Apart from saving for college, which you’re likely done with, you may want to cash-flow some of the expense for college or grad school for a few years. If so, you have to factor this in.
- The rest is discretionary spending- travel, eating out, spending on the grandkids. Or that boat. Pick your priorities. And your number accordingly. These are, after all, your golden years. You’ve worked hard to get there.
Annual Expenses Absent in Retirement
Once you sit down and list your likely biggest retirement expenses, you realize a lot that you spend money on now will not be present. For us, the biggest line items to disappear will be:
- Retirement savings: we put in about 35% of our gross pay towards retirement. Getting this out of the way will help!
- Taxes: prime earning years also coincide with prime tax paying years. We handed over one quarter of our gross income to the IRS last year.
These two biggest expenses account for 60% of our gross household income. Taxes will not be zero in retirement but a lot less.
There will be no Medicare and Social security taxes.
And assuming all your retirement income is taxed at ordinary income tax levels, and a comfortable $150,000 annual income in retirement, your effective Federal tax rate is only 16.5%. Go up to $200,000 and your effective Federal tax rate is 18%.
But this is an overestimation. A bunch of your retirement money is likely to come from taxable accounts- where you pay lower long-term capital gains tax rather than ordinary income tax rates. Even better, if you have a sizable Roth account, where no taxes are due on withdrawal, it brings down your taxes in retirement even further.
However, your situation may be different. For example, Dr Cory Fawcett, over at Financial Success MD, wrote this great piece on how all his retirement stash is in pretax money. So, he gets hit with nearly 25% in taxes on his retirement income. Be sure to account for it as part of your annual expense in retirement.
- House Acquisition costs: with the mortgage gone, it frees up a lot of cash flow.
- Kids: they’re cute but expensive. They need to be fed and clothed. And preferably educated. Once you’re done saving for college, if that is part of your goal, that’s another expense you will not have in retirement.
- Work related expenses: Gas, CME, licensing costs, child-care costs and a host of other expenses- all go away when you are retired.
Taking all this into account, I anticipate we will hover somewhere around $120,000-$150,000 in gross annual retirement expenditure, inclusive of taxes. Let’s take $120,000 for the rest of our discussion.
To be able to spend $120,000 a year in retirement, how much of a nest egg do I need? Let’s explore that now with a concept known as Safe Withdrawal Rate.
Safe Withdrawal Rate: The 4% Rule
A Safe Withdrawal Rate (SWR) is the amount of money you can take out of your retirement stash every year without being in danger of it running out.
This concept was first studied in two seminal pieces of work: Bengen’s Determining Withdrawal Rates Using Historical Rates in 1994 and Retirement Savings: Choosing a Withdrawal Rate That is Sustainable– popularly known as the Trinity Study- first published in 1998 and updated in 2011.
Safe Withdrawal Rate: Take Home Points
- As evidenced from the past, you can withdraw between 3-4% of your initial portfolio value and reasonably expect your retirement fund to outlast you.
Stated another way, the historical market return of 8-10% translates into a sustainable withdrawal rate of “only” about 4%.
- These numbers been studied for traditional retirement- durations up to 30-35 years. It may not quite work for the 40-50+ year timeline that early retirees are looking at.
- 4% refers to withdrawing that percentage of initial portfolio value at the time retirement begins.
- Subsequent withdrawals are an inflation-adjusted value of the same amount.
- The best asset allocation was found to be between 50-75% stock:bond ratio.
- For the 50% stock-50% bond portfolio, the median retiree ended up with nearly three times the amount of money they had started with.
- The terminal value of the portfolio depended on the withdrawal rate, the drawdown period, rate of inflation and the sequence of returns.
- You will find folks on both sides of this argument: those who think 4% is too optimistic and those who think it is too miserly.
- One way to reconcile this is to take 4% SWR as a starting point and adjust withdrawals along the way depending on how your portfolio is doing (Dynamic Withdrawal versus Static Withdrawal).
- How markets treat you- particularly towards the beginning of retirement has an outsize effect on the longevity of your nest egg. This is known as Sequence of Returns Risk.
- Another thing to remember is that spending is highest in the first few years after retirement- when folks are active enough to travel, etc. Spending goes down about 1% real a year on average only to ratchet up towards the end of life for healthcare-related expenses. This is called the Retirement Spending Smile, first published in a study by Blanchett in 2014.
Of note, taking this changing pattern of spending in retirement into account enables an individual to retire with a 15% smaller retirement portfolio than the constant withdrawal plan would allow.
Safe Withdrawal Rates: Caveats
- This guideline is based on past performance. The future is not guaranteed to resemble the past.
- Most of the study period is in the 20th century. Many authorities have warned stock returns and bond yields will be lower going forward.
- It was meant, even by the authors of the papers, to be a general planning tool rather than a strict rule of year to year withdrawal. Mid-course correction may very well be needed based on actual portfolio performance and expenses incurred.
- Retirees should be prepared that emergencies may not be covered by a 3-4% withdrawal- and that these may plummet their portfolios.
So, How Much Do You Need for Retirement?
Going by the evidence above, and aiming for a 4% withdrawal rate, I need ($120,000/0.04) or ($120,000 x 25) or a $3 Million nest egg.
If I think market returns going forward may not be as good as those of the last century- which is what constituted most of the Trinity Study period, I might want to reduce my goal to 3-3.5% SWR. This brings me to ($120,000 x 28-33) or $3.3-$4 Million.
The Effect of Inflation
We have not brought inflation into the equation above. This is because I will account for it in how I calculate expected returns on my portfolio. Instead of nominal returns, I use real returns.
Real Returns= Nominal Returns – Annual Rate of Inflation
We will talk about this in the next post- stay on the lookout.
Can I Calculate Exactly how Much I Need To Retire?
Short answer, no. Especially if you still have decades to go before you retire. This is only a place to begin. You have to track your performance both in the accumulation phase before retirement and in the distribution phase after retirement to make sure things are still looking good.
Hope this breakdown gives you a starting point at look at your retirement savings. Please let me know your thoughts. Thank you for reading!
This was a nice primer on retirement , and I’ve never been introduced to the spending smile concept before. My sense is people find this uncomfortable to think about. We are talking about amassing a huge amount of money, but not to spend on fun things- to spend on healthcare and convalescent care. Kudos to you for writing this explanation.
Hi Tired SuperHeroine, first, let me tell you how much I love your name! Thank you for reading and for the kind comments. We are all saving up both for the good and bad that’ll come along- much like everything else in life. The spending smile concept in retirement is fairly new- first published in 2014 by Blanchett. It is one of the rebuttals to the 4% rule- that one doesn’t need to amass all that amount before retiring. I am not accounting for it in my own retirement calculations- I am sticking to the usual formula. If there is surplus left at the end, as it’s likely to be, all the better.