Are you saving enough for retirement? Can your investments support your retirement spending desires?
These are difficult questions to answer. It boils down to how much money you need in retirement to maintain an acceptable lifestyle.
Unless you are close to retiring, you likely don’t have a good grasp of your retirement spending needs. How much you need to save is directly related to how much you plan to spend.
Plus, will you have other sources of income in retirement such as Social Security and/or a pension?
A steady source of “guaranteed” income in retirement can dramatically lower your savings requirement. But you need to consider that a lot can change in the future. What you thought was a reliable source of income, could turn out to be less “guaranteed” than you thought.
Finally, how is your health and family history? Many studies on retirement spending assume a 30-year retirement. Assuming you retire at 65, is it realistic you or your spouse will live to age 95?
Even with the complexity of the question, there are rules-of-thumb regarding retirement savings and spending.
This post explores the “4% rule” which states you can safely spend 4% of your savings in your first year of retirement.
The 4 Percent Withdrawal Rule
The “4% rule” states you can spend 4% of your retirement savings in your first year of retirement.
For subsequent years, take the dollar figure from the first year, and increase it by the inflation rate.
For example, if you retire with $500,000, you can spend $20,000 from savings the first year (4% * $500,000 = $20,000). Assuming inflation is 3%, you could then spend $20,600 your second year of retirement ($20,000 + ($20,000 *3%) = $20,600).
You continue to grow your spending each year by the prior year’s inflation rate, regardless of whatever is happening with your investments.
A 4% withdraw rate is a good rule-of-thumb to keep in mind while saving. Yet for most people, I believe the assumptions behind this figure are probably too conservative.
Studies that arrive at a 4% rate for safe withdrawals generally assume a 90% probability of success (i.e., your savings lasting through retirement) and a 30-year retirement.
Note that the studies also assume you remain invested in a diversified portfolio of stocks and bonds. Your odds of success would be lower over 30 years if invested in a highly conservative portfolio of bonds.
Implications
Let’s think for a minute about what these assumptions imply.
For one, as I mentioned above, if you retire are 65, the assumption is you live until age 95.
Considering life expectancy for a 65-year-old in the United States is 18.5 years, only a minority of people will reach age 95. (Center for Disease Control; Health, United States, 2020)
Secondly, the analysis is based on a 90% probability of your money lasting until age 95. This means there is almost a 90% probability you will have money remaining even after 30 years of withdrawals. In most “average” scenarios (or the 50% probability case), your savings will have increased, and you will have more assets than you retired with.
One of the reasons for such conservative assumptions is to address people’s fear of running out of money. Most people wouldn’t be comfortable implementing a financial plan with a 50% chance of running out of money if they happen to live beyond their life expectancy.
The prevailing assumption is it is better to be conservative in your retirement spending to ensure you can maintain a constant spending level throughout retirement.
Alternative Approaches
Alternative withdrawal rules have been proposed. Most start with a slightly higher rate (e.g., 5% in the first year), but adjust spending based on investment performance.
For example, if the market declines the first year of retirement, perhaps you don’t increase your spending for the next year.
These alternative approaches allow a retiree more income early in retirement. But they lack the simplicity of the “4% rule” and require you to curtail spending if your investments perform poorly.
But frankly, I think this is probably a more natural human tendency. If your nest egg declines, it is more natural to cut back on spending than withdrawing an increasing amount from a declining investment portfolio.
Getting back to the original question, how much should you be saving for retirement?
Even with all its flaws, the 4% rule is a good basis for retirement planning.
Hence, if you want your investments to support another $3,000 per month in spending (after expected Social Security and pension income), you should target savings at retirement of around $900,000.
We arrive at this figure by dividing the desired annual spend of $36,000 (12 months * $3,000/month = $36,000) by 4 percent.
If you are comfortable being a little more aggressive, perhaps you want to start with a 5% withdrawal rate, which would require $720,000 in savings.
Additional Resources:
Here are a few sites with additional details on safe withdrawal rates in retirement:
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