As part of rolling over my 401(k), I’ve been spending some time with my retirement investments. I’ve tweaked my asset allocation and rebalanced my investments. And as part of this overhaul, the question of just how much money we need to retire has been on my mind.
So I did some research into the question. I found a few rules of thumb used by the “experts” when advising clients. While the exact amount needed for retirement varies a bit from one expert to another, the general rule is the following:
(Yearly Income Needed – Social Security and Pension Payments) x 25
Let’s look at an example. Suppose you need $100,000 a year during the first year of your retirement. Let’s also assume that you’ll receive $25,000 in social security or pension payments. Reducing your income needs by the social security and pension payments leaves you with $75,000 that will need to come from retirement savings. Multiplying the $75,000 times 25 gives you how much you need to retire–$1,875,000 in today’s dollars.
Why the rule of 25?
So what’s the logic behind multiplying your retirement income needs by 25? The theory assumes that you’ll earn about an 8 percent average return on your investments during retirement. In order for your retirement assets to keep pace with inflation, you’ll keep 4 percent of your returns in your investment portfolio, and withdraw the other 4 percent to live on.
It’s this 4 percent withdrawal rate that gets us to the rule of 25. Four percent of $1,875,000 is $75,000, exactly what we needed from our retirement investments in the above example.
There are no guarantees
As you can see, there are a number of uncertainties when estimating retirement needs. While we can do our best to project what we’ll need to live on during retirement, expenses could always turn out to be higher or lower. And we can’t assume our investments will actually return eight percent. Maybe they will return less. And a four percent inflation rate, while reasonable based on historical standards, may prove to be grossly understated.
Because of these many uncertainties, financial experts offer a range of ways to calculate how much one needs to retire.
A survey of the experts
Some experts believe that a safe withdrawal rate is just 3%. As a result, they advise saving 33 times your annual income needs in retirement. This is the rule of thumb suggested by Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI).
Sydney Lagier, writing for MSN, believes that 33 times income is needed if you are younger than 50. For those in their 60′s or 70′s, however, he believes a percent withdrawal rate is reasonable, requiring just 25 times needed income.
The Wharton School of Business believes you should assume that you’ll need 100% of your pre-retirement income, not 70 to 75 percent recommended by many financial advisers.
Vanguard advises withdrawing no more than 3 to 5 percent per year during your earlier years in retirement. While this may seem like a narrow range, the amount of money you need saved for a 3 percent withdraw rate (33 times your yearly income needs) is dramatically different than if you used a 5 percent withdraw rate (20 times). The more you take out each year, the more likely you are to run out of money in retirement.
Fidelity sticks with 25 times your yearly income needs, but with lots and lots of caveats.
Over at Morningstar in an interview of a Boglehead (a group named after Jack Bogle, the founder of Vanguard), a 4% withdraw rate is viewed as the most you can safely take out of your retirement savings (which yields a 25 times rule).