This is a guest post written by Todd Tresidder.
How do you know if you are saving enough so you can afford to retire? And more importantly, are you saving enough to retire with confidence so that you can support your present lifestyle without running out of money early?
To answer these questions, you might consider using one of the many online retirement calculators available. Unfortunately, these “simple” retirement calculators are often complicated and require you to assume many things about your future retirement that may or may not work out to be true. It’s the old “garbage in equals garbage out” rule, and nowhere is that rule more true than with retirement calculations.
One alternative to sophisticated retirement calculators is to apply simple rules-of-thumb that allow you to quickly and easily estimate the sufficiency of your nest egg and savings plans. While these simple formulas lack the “rocket science” sophistication of Monte Carlo theory and other financial planning innovations, they do provide a reasonable ballpark approximation that is easy enough to do yourself – without a computer, software, calculator or financial planner. Usually, a pencil and the back of a cocktail napkin are sufficient.
The advantage of this simplicity is you will actually complete the exercise – which is essential to successful retirement planning. You must know the retirement savings goal you are aiming for in order to plan constructive actions to reach the goal. You are far better served by knowing a rough approximation of your retirement planning needs than to have no estimate at all.
The truth is perfection in retirement planning is impossible anyway because accuracy depends on assumptions about your future which can never be made with certainty. Therefore, it’s better to at least work with ballpark estimates than to risk being thwarted by complication that might keep you from playing the game altogether.
Below are four simple rules-of-thumb for retirement planning that will at least get you in the ballpark until you have the time and inclination to sharpen your pencil…
The Ten Percent Rule
Some old-wives-tales are true, and the importance of saving 10% of your income happens to be one of these truths. This retirement savings strategy was popularized in the bestselling book The Richest Man in Babylon. In general terms, the way the math works is if you save 10% and invest it with long term returns around 10%, your investment portfolio will grow to the point that it can support your lifestyle from earnings in roughly 35-40 years. That means you could retire and live on the investment earnings alone, never touching the principal. Your life expectancy doesn’t even matter in this situation because you would never run out of money since it doesn’t require you to spend principal. The biggest risk to this simple formula is inflation, although even with that limitation it still provides a good working approximation for how much you should be saving.
What’s fun about this formula is how easy it is to understand, easy to implement, and easily adapted to your situation. For example, if you have less than 40 years until retirement then you should obviously be saving significantly more than 10%. The sooner you start saving, the longer you have for your interest to compound to build your retirement fund. If your average investment return exceeds 10%, you won’t need to save as much. If it is less than 10%, you need to save more.
One big benefit to using this simple rule-of-thumb is you don’t need to pay for a fancy financial plan that sits in the binder on your shelf collecting dust to get started. It is a rough approximation that points a clear direction so you can get started immediately – and starting immediately is a critical factor to your retirement savings success.
The “Millionaire Next Door”
Now that we have a reasonable approximation for how much you should be saving each month, lets examine a different approach that provides an approximation for how successful your savings efforts have been to date.
According to The Millionaire Next Door, authors Stanley and Danko provide a simple yet reasonably accurate formula for assessing your wealth accumulation skills:
Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.
For example, if you are 35 years old and earn $100,000 per year with no inheritances, then your net worth should be $350,000: 35 times 100,000 divided by 10 equals 350,000. If you meet this standard, consider yourself to be “on track” for moderate wealth accumulation and a successful retirement fund. You aren’t a super achiever, but you aren’t behind either.
Go ahead and do the math for yourself. How do you measure up? This formula is really just another twist on the 10% savings rule cited earlier. It is based on sound mathematics and seems to provide a conservative but realistic figure for a broad range of scenarios.
Although it does not consider inflation, taxes and varying interest rates, this simple formula does yield a useful estimate of your retirement savings goal. It gives you a fast and easy way to see how well you are progressing toward financial freedom.
Stanley and Danko go one step further, creating two additional benchmarks based on their basic formula. “Prodigious accumulators of wealth,” or PAWs, have accumulated twice the savings indicated by the formula. “Under-accumulators of wealth,” or UAWs, have accumulated half the expected total. If you are a PAW then you are reasonably on track to knowing if you can afford to retire. If you are a UAW, now is the time to step up your financial management skills and start saving more.
12 Times Income
Jonathan Clements, former columnist for theWall Street Journal and author of The Little Book of Main Street Money: 21 Simple Truths that Help Real People Make Real Money, offered another alternative to the “How Much Money Do I Need To Retire?” question by claiming a reasonable retirement nest egg should be 12 times your income. To reach this goal, the amount you need to set aside each month depends on how much time you have before your target retirement age and your current savings-to-income ratio. This premise makes a few assumptions:
- your income increases to match inflation,
- you draw 5% of your savings as income the first few years of retirement, and
- you achieve an investment return of 5% after inflation.
The numbers purport to yield 60% of your pre-retirement income. Combined with Social Security and other income, you might end up with 80%, a figure that most retirement calculators assume is enough. Alternatively, if your own calculations show that you need a higher percentage, then you need to amass more than 12 times your income.
Rule of 25
One of my favorite rules for simplifying how much is enough to retire is to multiply your expected annual spending for your first year of retirement by 25 to determine your total savings required. This is just a mathematical simplification of the famous 4% rule where you are allowed to spend 4% of your savings each year during retirement.
This rule is on firm empirical grounds because the sophisticated retirement planning models including Monte Carlo optimizations will generally result in spending rules ranging from 3-5% depending on assumptions and confidence interval required. Now you can get roughly the same result without a computer, software or arcane mathematics. Just take your first year of retirement spending, multiple it by 25, and presto – you are right in the same ballpark.
These quick and dirty rules of thumb are far from perfect. But the ugly truth about retirement planning is there is no such thing as perfect. In the end it is all a rough approximation anyway. For those readers wanting more explanation and detail, the ebook “How Much Is Enough To Retire” will help you understand exactly when you can afford to retire.
The future is unpredictable and conventional retirement planning requires you to predict the future in order to apply their models – this is a serious flaw. The truth is many unknowable factors will determine your financial needs during retirement, and those will only be known in the fullness of time. There are alternative models to retirement planning that don’t require you to see into the future and for those readers who don’t have the time or inclination to learn those models, this article provides some simple rules that will get you close enough for basic planning.
The important thing is to develop a concrete retirement savings goal to work toward – regardless of the model used. An inaccurate goal is better than no goal at all. You can use these simple rules of thumb to get started today and sharpen your pencil later when accuracy becomes more important.
About the Author
Todd R. Tresidder is a financial coach who retired comfortably when he was just 35 years young. His ebook, How Much is Enough to Retire? is based on his own experiences and explains how you, too, can afford to retire. Check out his web site for more retirement planning books, educational articles, and try his free retirement income calculators.
photo credit: ted.sali