How to Calculate Your Retirement Savings Needs

Laughing retired couple sitting in grass near two bicycles.

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One of the most difficult parts of retirement planning is calculating how much money you should aim to save before retiring. According to the U.S. Government, the three most common options to save for retirement are:

  1. Retirement plans offered by an employer
  2. Savings and investment
  3. Social Security

There are several guides that list percentages you should try to hit. For example, many financial experts say you want to replace between 70% to 85% of your pre-retirement income. If you earn $100,000 a year, your goal should be to create enough retirement savings that you would be able to live on somewhere between $70,000 to $85,000 per year. In the U.S. people live an average of 20 years after retirement.

Problems Basing Retirement Needs on Current Income

Unfortunately, this rule of thumb isn't helpful for people who are in the early stages of their careers. If you're in your 20s or 30s, you're likely earning an income that reflects your entry or intermediate-level position within a given career. If you're in the middle of your career but have decided to make a career change, you may also temporarily experience lower pay that affects your retirement-savings formula.

When you're unsure what your pre-retirement income is going to be, it becomes difficult to project the amount you'll need during your senior years.

What If You're a Saver?

Another problem with the "replace your income" rule of thumb is that this advice hinges on the assumption that you spend the majority of your income.

If you typically save 10% to 15% of your income for retirement and perhaps another 10% to 15% of your income for other non-retirement types of savings, then the implication would be that you spent somewhere around 70% to 85% of your income.

It makes sense under that very specific set of circumstances that if you spend the majority of what you make and you don't expect your spending habits to change whatsoever during retirement, then you would need to create enough money so everything would stay the same.

However, it isn't necessarily the case that people spend the bulk of what they make. Some people spend more than what they earn, ending up in credit card debt, while others spend significantly less than the amount that they earn.

This is the second, more compelling reason why basing your retirement projections on your former income (rather than your projected expenses) is not the best framework for planning. 

Focus on Spending, Not Income

As such, it's wise to calibrate retirement projections on your level of spending rather than on your income. This solves both of the two problems addressed above.

The Bureau of Labor Statistics saw a 1.5% decrease in income and a 4.8% increase in expenditures in their 2018 consumer report. Among the different categories, personal insurance and pension expenditures represented the largest percentage increase with a 7.8% rise, followed by a 2.5% rise in food expenditures. The only decrease among the largest categories was a 5.6% drop in educational spending.

Your spending in retirement will most likely be different than your spending today. In retirement, for example, you may not have a mortgage payment. Your children may be grown and living on their own, and you'll no longer need to support them. Costs related to your work such as childcare, business attire, and commuting costs will also dissipate.

You will have other expenses that you don't currently have today. Out-of-pocket prescription and medical costs will might be a bigger concern. You may also want to outsource home-related tasks that you currently do yourself such as cleaning gutters, raking leaves, or shoveling snow when you're in your 70s. You may also choose to travel more or use your retirement to explore hobbies that you couldn't pursue during your working years.

All of this leads to a second quandary, which is that while income is not a suitable basis for determining how much money you should have in your retirement portfolio, expenses are not a perfect option either. However, in lieu of better alternatives, expenses may be the best benchmark for how large of a portfolio you should aim to create.

Assuming that some of your current expenses will decline but others will grow, then it's reasonable to project that the amount you currently spend will be close to the amount you spend during your retirement years.

Multiply Current Annual Spending by 25

Here's a broad rule of thumb that you can use to determine the amount of money you will need when you retire. Multiply your current annual spending by 25. That's the size your portfolio will need to be in retirement for you to safely withdraw 4% of that portfolio amount every year to live on. 

For example, if you currently spend $40,000 per year, you will need an investment portfolio that's 25 times that size—$1 million at the beginning of your retirement. This sum is large enough for you to withdraw 4% of that $1 million retirement portfolio in your first year of retirement, and that same 4% adjusted for inflation every subsequent year, while maintaining a reasonable chance that you won't outlive your money. 

This may sound daunting, but if you begin saving for retirement at an early age—as early as your 20s—you could amass a $1 million portfolio even on a salary of only $30,000 to $40,000.

If You Got a Late Start With Saving

If you're starting later in life, don't despair. The key thing that you need to remember is that the best way to compensate for getting a late start is to aggressively contribute to your accounts.

Save Harder: The older you are, the more you should be saving and diversifying for retirement each month. Don't over-allocate a portion of your portfolio to stocks on the grounds that you need riskier investments to compensate for lost decades of savings. Risk cuts both ways, and if your investments suffer, you won't have as much time to recover.

Use Index Funds: Look for low-fee index funds and spread your investments between a reasonable mix of stocks and bonds. Keep continuing to do that regularly through the rest of your working career with a goal of saving 25 times your current level of spending by the day that you retire.

Keep on Track: Use retirement calculators to make sure that you are on track, and don't pay too much attention to scary headlines in the financial news. You are playing a long-term game, and getting caught up in the daily turbulence of the market will only curb your progress.

If you're saving for retirement with a late start, focus on ways that you can either boost your income or lower your expenses. If you can, do a combination of both.

Redefine What Retirement Means

By 2024, the Bureau of Labor Statistics projects that the labor force will grow to about 164 million people. That number includes about 41 million people who will be ages 55 and older—of whom about 13 million are expected to be ages 65 and older.  

"People are working later in life for a number of reasons. They are healthier and have a longer life expectancy than previous generations. They are better educated, which increases their likelihood of staying in the labor force. And changes to Social Security benefits and employee retirement plans, along with the need to save more for retirement, create incentives to keep working."

If you got a late start to saving and need to earn more to make up the difference between what you need and what you have, consider a few alternatives before you "officially" retire:

  • If you love your job, it could make sense to stay and take advantage of employer-matching contributions alongside catch-up contributions to your 401(k). Not to mention, you get to keep your other benefits a little longer.
  • Use your decades of experience to work part-time as a consultant for a few years while your money continues to grow.
  • Start a second career in something you've always been passionate about. If taking a pay-cut allows you to be on track to meet your retirement savings needs, embark on a new journey in a new industry for a few more years.

Redefine Lifestyle in Retirement

Maybe you didn't get a late start with saving but can't spare the extra change to build a portfolio that reflects your current level of spending. 

If earning extra money isn't possible, then you might have to redefine what kind of lifestyle you want to live in retirement. There are plenty of ways to cut costs and maintain an active lifestyle in retirement. 

Instead of keeping the house you currently own, it may make more sense to downsize and retire to a state with no income tax. You could take it a step further and retire someplace overseas that has a lower cost-of-living.

There are plenty of ways to make retirement work, you just need to play with the numbers to see what's possible for you. Even if you don't envision a $1 million retirement portfolio, save what is reasonable for you, and then evaluate adjust the habits that define your lifestyle.