How much money do I need to retire? That is a very complex question for many and the answer is that it depends on a number of factors. In the end, there is no guarantee. What you are aiming for is a high level of confidence that your plan works.
Let’s walk through the critical questions to answer this question.
Age related questions
One important set of questions hinges upon your intended retirement age and your average life expectancy. If you are married your spouse will have to answer the same set of questions.
Your retirement age matters because the earlier you retire, the longer the money needs to last. For example, let’s assume your life expectancy is 85 years. If you retire at 50 the money will need to last 35 years. If you retire at 65 it will need to last 20 years. That is a big difference!
Of course this line of questioning is quite difficult because we don’t know how long we are going to live. All you can do is use a reasonable set of assumptions and move forward from there.
Expense questions – what are they now?
In order to determine the amount of money you need to retire, you need to estimate what your cost of living is going to be. In order to confidently estimate what your future expenses are going to be, it’s quite helpful to know what your expenses are now.
Start first with your monthly expenses over the last two or three months. These would be all the frequent expenses your incur each month. You know, things such as food, transportation, merchandise, utilities, etc.
Then, you should look at your annual and infrequent expenses over the last year. Those would include vacations, home improvement projects, real estate taxes, car repairs, etc.
By doing both of these things you should be able to come up your estimated annual expenses over the last 12 months. This is a good starting point to estimate what your typical expenses will be once you retire.
If you own a home and expect to be in a home going forward, you have more calculating to do. You are likely going to have larger ongoing expenses that will be very infrequent. Those would include replacing mechanical equipment such as your furnace, air conditioner, water heater, stove, washing machine, etc. You also would likely have large, but very infrequent expenses such as replacing a roof, siding and flooring. This can be difficult because you don’t know exactly when these items will fail.
One rough rule of thumb I like to use is 2%-3% of the home’s value to be reserved each year for these capital expenditures, repairs and maintenance items. So, for example, if you have a $200,000 home you might estimate, say 2.5%, or $5,000 per year for these things. Another way to estimate this would be to list out all of these things (roof, siding, stove, water heater, etc) and forecast when they would likely be repaired and at what cost.
Your goal in this process is to determine what your average annual expenses have been running, including infrequent expenses. For the infrequent expenses, it is helpful to break them down into an average annual expense to help with the ease of calculations.
The expense side is absolutely critical to estimate as accurately as you can. If you get the expense side wrong by too much you are going to be in trouble.
Expenses – what are they likely to be in retirement?
After you get a handle on your current expenses, you need to determine what they will likely be after you stop working.
Medical expenses will be a big deal in retirement. What will the dollar amount of your annual health insurance premiums be? If you are not old enough for medicare you will likely be buying a policy on the health care exchange. That could be much more expensive that what you were paying when employed. Regardless, you need to estimate these costs as part of your retirement expenses.
What about travel? Are you going to be traveling more than you do now? If so you need to estimate those annual expenses and add that to your current annual expenses.
Some expenses will likely go down. If you are commuting to work, those costs will be going away. The same with work clothes. Those costs will disappear.
Ideally you want to eliminate any debts before retirement, such as student loans, car loans, and mortgage loans. If not you should have a payoff plan that is factored into your retirement plan cash outflows.
On a spreadsheet you can list all the expense categories. In one column you can put your current average annual expenses. In the next column you can put your expected annual expenses once retired.
You now have a reasonable estimate of your expenses for your first years in retirement.
One additional step would be to put additional columns with an annual inflation rate assumption. For example, if year one of retirement you have $80,000 in expenses and you assume a 3% inflation rate per year, your year two expenses would be $82,400 ($80,000 + $2,400 of inflation).
What sources of retirement income will I have?
You then want to account for any other income sources you expect to have. This annual income number will be an important piece to the puzzle.
If you are lucky enough to have a pension, you can put in the year you expect the pension to begin and the amount per year going forward.
The same with Social Security Income. If you go to the social security website you should be able to lookup your account and see your expected social security benefits. You will need to determine if you plan to take social security early at a lower amount, wait until the full retirement age, or hold on until the maximum benefit.
If you have any rental properties you would add that expected cash flow as well. Be sure to add any other reliable income streams you expect to have.
Will you work a part-time job? You may want to have some work. It may be a helpful piece to get your retirement numbers to balance. For some you may need to work part time (or more) in order to get the math to work.
Time to run some numbers
Let’s say that you have calculated that you expect to spend $80,000 per year in retirement. Let’s also assume that you have a pension plan that will pay $15,000 per year and social security that pays $30,000 per year. That leaves you with $35,000 yet to cover ($80,000 – $15,000 – $30,000 = $35,000).
So now you have determined at a high level that you will need $35,000 withdrawn each year from your retirement and investment accounts to cover your remaining expected expenses. You will next need a safe withdrawal rate assumption. This would be the percentage per year that you can expect to safely withdraw out of your investments and not run out of money in a typical 30 year retirement. If you are planning for an early retirement (more than 30 years in retirement), you would likely need to consider a permanent withdrawal rate (lower rate) rather than the safe withdrawal rate.
One safe withdrawal rate rule of thumb starting point is the 4% rule. This was developed by William Bengen back in the 1990’s. It stated that for the typical 60/40 Stock/Bond mix you could withdraw 4% of your portfolio’s value in year 1, and increase it for inflation each year thereafter, and not run out of money in a typical 30 year retirement.
Decades later, the 4% rule of thumb is still used quite a bit today as a good starting point. You ask, how can that be? If the stock market has averaged over 7% in real returns (returns after inflation) over the last 50 years, why is the safe withdrawal rate only 4%? The reason is market volatility. The market has crashed 20% or more a number of times over the years. The old logic was to withdraw as much as the market returns, and that was a faulty assumption. Retirees were running out of money. The 4% rate was calculated to factor in market volatility (up and down swings) over the decades.
The sequence of return risk is one of the biggest financial concerns in retirement. The worst case would be a big market crash right around the start of retirement. This is because you are withdrawing funds and not contributing. You are doing the opposite of dollar cost averaging. You are pulling money out when the account balance is down, which drives it down further. If your account balance is driven down far enough, you may be unable to recover as your continued withdrawals could outpace what the investments could produce, putting your investments on a downward death spiral.
The beauty of the 4% rule is that it accounts for the likely crashes. In other words, 4% is a good rule of thumb that includes market crashes and volatility.
In our example, let’s say you have $35,000 of expenses to cover after considering a small pension and social security. If you take the $35,000 and divide it by 4%, you get $875,000. That is a good starting point. It means that you could draw 4% of your investments each year (plus inflation) and have a high probability of not running out of money for 30 years.
Looking at our example again, if you did not have a pension, you would need to cover $50,000 of expenses per year. If you take $50,000 divided by 4% your come up with $1,250,000. That is the savings you would need to have to generate $50,000 of income per year.
Finally, if you didn’t want to rely on social security, or were retiring earlier, you would need to cover the full $80,000 of expenses. If you take $80,000 divided by 4% you get $2,000,000. That is the number you would need to generate $80,000 in income to cover your expenses.
So, to answer the question if $2 million is enough for you to retire. The answer here would say you could retire with that amount if your time frame was 30 years or less, you invested the money properly, and your spending is $80,000 or less (inflation adjusted each year going forward).
Investments
The reality is, your money has to go somewhere. It is either in cash, a bank savings account, an investment account, real estate, or some other asset. Every choice has its pros and cons. Take too little risk with investments that pay low interest rates (bank accounts, CD’s) and inflation will eat you up your purchasing power over time. Take too much risk in speculative or high risk investments and you could lose your retirement savings much faster!
In order for your investments to support you for a comfortable retirement, you need to have a carefully constructed investment strategy that includes your risk tolerance and retirement goals.
Invested carefully, you should expect to achieve at least a 4% withdrawal rate as discussed earlier. There are many asset class choices available today to allow you to construct a portfolio of carefully constructed uncorrelated investments for lower volatility and a higher safe withdrawal rate.
There are lots of ETF and Index Fund accounts that allow you to invest with good diversification at low cost. It has never been easier for the DIY investor! See the Portfolio Charts website for many common portfolios and their historical safe and permanent withdrawal rates.
Get an Independent opinion
Your financial future is too important to do it in a vacuum. We all have blind spots (things we don’t know or didn’t see coming).
It makes sense for you to go through all the steps and do your own calculations. Once you feel that your plan is good, it then makes sense to get an independent opinion.
Be sure to go to a Fee Only Financial Advisor that would be willing to update your plan and confirm if you are good or not. That person should be a certified financial planner that has signed a Fiduciary Oath that requires them to do what is in your best interest. Two firms to consider would be the XY Planning network and the Garrett Planning network.
Watch out for snake oil salesmen trying to sell you high commission insurance products done to enrich them, not you!
Planners will use software to run numerous Monte Carlo simulations to give you the expected probability of success for your plan. It will be a good validation of your own calculations and assumptions!
When to pull the trigger and retire
Giving up your full time job with a good income is scary. You definitely want to make sure your plan is solid before you make the leap.
We all hear a lot about the one year syndrome. These are workers that keep working just “one more year” so that their plan gets safer and safer.
That might seem logical and safe at the moment, but there is another opportunity cost that one could argue is far greater. That is the cost of time. Time is finite and we can’t get more of it. How do you want to spend it? That is the question we all need to ask ourselves.
We all need to keep in mind that after you have “spent” another year of time, you can’t get it back.
Don’t forget about taxes
We didn’t discuss taxes much in this article, but they are an important expense that must be included in your retirement plans. Your projection model needs to include taxes as part of your expenses. You need to make sure you can cover all your expenses, including taxes.
Funds in a Roth IRA or in an HSA are more valuable than any other, as they are tax free if spent as required by the tax law.
If you plan to retire early, note that there are rules surrounding Roth IRAs, Regular IRAs, etc that must be followed. Generally speaking (there are exceptions) you will get hit with a 10% penalty if you begin to withdraw funds before age 59.5. There are some exceptions such as the rule of 55 (for 401k plans that offer it) and a 72(T) election.
If you are planning to retire early be sure to get this figured out by discussing this with a financial professional. You will need to account for both taxes and penalties if you don’t qualify for one of the exceptions. Both of these need to be factored into your cash outflows for the applicable years.
What levers can you pull if your retirement is not going as planned?
Note that a retirement plan is just a plan. It is going to be wrong because they are so many variables and scenarios that will be different than you expected. That is okay. As long as your asset values are in a reasonable range from your projections, you are good.
But what if things are not going as planned?
Most plans assume your expenses will go up linearly over time. That is not reality. If times get tough (just like with Covid-19) you will adapt. You can cut back on vacations and discretionary spending. You can do seasonal or part-time work. You could downsize your living arrangements. There are many different things you can do to get your retirement plan back on track.
Once your assets get back in the target range, you can likely go back to your planned spending. Being able to adapt and adjust is the key to any successful plan execution!
Summary: Is 2 million dollars enough money for me to retire?
- Determine your expected retirement age and assume a life expectancy age
- Get a good handle on today’s expenses, and then project your retirement expenses
- Determine the amount and timing of your expected retirement income sources
- Your investment selections will help you determine a reasonable safe withdrawal rate
- Your income sources plus the safe withdrawal rate on your investments will determine the expected inflows available to cover your expected expenses
- Be sure to get another opinion from a fee only Fiduciary planner
- It’s scary to make the leap into financial independence, but the opportunity cost of consuming your finite time might be even greater
- You can make adjustments during retirement to help get your plan on track
