Some years ago, there was an inane commercial (here) that reinforced the belief that everyone has “a number” - the amount of money you need to retire. Once you hit that number, you will be all set to enjoy your golden years.
If you want to figure out when you can afford retirement, focusing on how much you have saved isn’t as helpful as you may think.
The most useful data point relates how much you will have at retirement and how much you spend - your withdrawal rate. It’s the percentage of your savings that you will spend every year. Calculating your withdrawal rate before you retire is the best way to confirm that you can afford to give up your paycheck.
Here’s what you need to know.
- You’ll need to project income and expenses. Be realistic about what you will spend. In early retirement, your travel expenses may be high. In late years, you may have nursing care costs. Don’t forget your tax bill, which can be high if you have significant required withdrawals from retirement accounts.
- What you can take in year 1: If you retire at age 65 and expect to live an average lifespan, you can probably withdraw about 4% of your savings in your first year of retirement. If you withdraw that same dollar amount in future years, adjusted for inflation, you will likely have enough throughout your life. This is the so-called 4% rule.
- What could impact whether you start at 4% or a different withdrawal rate: A lot. If you retire before age 65, expect to live much longer than average, invest very conservatively, or want to build in extra cushion, you may want to start at a lower percentage, like 3%.
- What your withdrawal rate will look like in later years of retirement: Because the amount you are withdrawing goes up yearly with inflation – and your investments will be more volatile – the withdrawal rate will likely increase over time. Typically, it will be closer to 6-10% in the mid-80s. A variety of factors will influence your situation.
- How to be even more confident you won’t run out of money: Adopt guardrails. They kick in when the stock market drops significantly, or inflation is high. For example, you could decide your annual withdrawal rate will never go up by more than 1-2 percentage points from the previous year, forcing you to cut expenses in certain years.
- Another step to reduce risk: Some academic studies suggest becoming extra conservative in your investments beginning a few years before you retire. This strategy mitigates sequence of return risk. Put simply, the worst time for a bad stock market is in the years just before you retire when you typically have the most financial assets.
- The impact of inflation. Inflation – not just the stock market – will impact your financial plan in retirement. If you rely heavily on annuities, be particularly careful. Annuity payments typically do not adjust for inflation, which may force you to take more from your investments. By contrast, over time, stock prices should go up with inflation. Inflation tends to be a higher risk for conservative investors with a lot of bonds or annuity income.
The calculations can get complicated. That’s why it often makes sense to hire a financial planner. But the basic idea is simple. Saving a lot of money leading into retirement is great. But unless you have unlimited funds, expense control is just as important.