The trouble with planning for something with so many variables is that it can often be overwhelming. Chances are you have questions. How much money will you need? When will you be able to retire? Are you saving enough? At some point along the way, everyone asks one or all of these questions.
Your instinct may be to call your financial planner or CPA every time you wonder (worry) about whether you are saving enough for retirement. However, it is often easier and more practical to use rules of thumb and/or estimates to get an idea of whether you are on track. These rules — including the newer Retirement Account Multiple (RAM) — can work to quickly ease your mind.
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The 4% Rule
Perhaps the most commonly known rule of thumb is the 4% rule. The darling of retirement minded savers and aspiring early retirees everywhere, this is a withdrawal guideline based on an academic paper known as the Trinity Study.
Essentially, the 4% rule proposes a “safe withdrawal rate” of 4% of your retirement portfolio each year in retirement, allowing the remaining balance to continue to grow. By withdrawing no more than 4% per year, your chances of outliving your investments over a 30-year retirement are extremely low. For example, if you retire with a $1 million portfolio and follow the 4% rule, it is “safe” to withdraw $40,000 per year to spend in your retirement.
Make Retirement Easier and Cut Expenses Now
Is the 4% rule perfect? Certainly not. But it is helpful in thinking about where you stand in terms your retirement savings.
For example, following the 4% rule, you could calculate an estimate of how much you could withdraw from your retirement accounts if you were to retire today. If you currently have $250,000 saved for retirement, you could theoretically retire today and pull out around $10,000 per year ($250k x 4%). If $10k a year doesn’t sound like enough, perhaps you should keep saving.
On the other hand, you can also use this rule to estimate how much you should save. You want to withdraw $50k per year, beginning in year one of retirement? Then, according to the 4% rule, you’ll need to save $1.25 million.
If thinking about your retirement savings and withdrawals in terms of the 4% rule isn’t working for you, there are other rules of thumb you can use. Let’s take a look at this fairly new one, the Retirement Account Multiple.
The Retirement Account Multiple (RAM)
Simply put, the Retirement Account Multiple, or RAM, is a shorthand way of thinking about your retirement account balance in relation to your annual salary during your last year of work. Take your retirement account balance and divide it by your final salary… that’s your RAM.
For example, if your final year’s salary was $75,000 and the balance of your retirement accounts is $750,000, your RAM would be 10. ($750,000 / $75,000 = 10)
Okay, great, so you know your RAM… now what do you do with it?
What Your RAM Can Tell You
Once we know the RAM, we can use it to calculate whether you are on track for retirement. We use it to provide similar guidance as the 4% rule, only we aren’t limited to taking a 4% distribution each year. This means you can get a more accurate estimate, with more flexibility.
Say your retirement account balance and RAM are the same as the example above. Perhaps you have a more optimistic outlook on your potential investment returns, and you feel comfortable withdrawing 5% from your portfolio each year. Using the RAM, we can calculate the percentage of your final salary that your current retirement savings will replace.
If we multiply the RAM by the withdrawal percentage (in this case, 5%) we get a figure known as the Income Replacement Ratio (IRR). Let’s apply it to the above example. Your final year’s salary is $75,000 and your RAM is 10. So, 10 (RAM) x 5 (withdrawal %) = 50% income replacement.
More specifically, you plan to withdraw 5% of the $750,000 retirement account per year. This works out to be $37,500, which is 50% of your $75,000/year final salary.
Saving three-quarters of a million dollars just to replace half your income may seem like way more effort than reward. Plus, the thought of living on $37,500 per year might be a little scary. However, keep in mind that a 50% IRR doesn’t mean you have to cut your lifestyle in half just to retire.
The bigger picture
So, now we know that your RAM can tell you what percentage of your final salary will be replaced by your retirement account withdrawals. But it’s likely your retirement accounts won’t be your only source of income in retirement. Part-time work, social security, and/or a pension are just some of your other potential income sources.
Resource: MarketWatch’s Retirement Planning Tool
Say you just retired this year, with a monthly social security benefit of $1,875 per month. At $22,500 per year, that would represent 30% of your final $75k salary. Add the 50% IRR that your retirement accounts will provide, and you’ve replaced 80% of your income! This is likely close enough to effectively replace your entire income. If you’ve managed to save up enough in your retirement accounts to have a RAM of 10, you must have been living on less than 100% of your income during your working years, anyway!
Using RAM to calculate your withdrawal rate
The great thing about mathematical formulas is that by knowing certain variables, you can solve for the ones you don’t know. The RAM and IRR formulas are no different.
Let’s build on the example above and work backwards. Say you’re getting the 30% income replacement from social security (by the way, SSA.gov has some great calculators you can use to estimate your future social security benefits). Let’s also assume that you are lucky enough have a small pension which will replace an additional 30% of your income.
Assuming that you still only need 80% of your final salary to retire comfortably, that means you’ll only need your IRR from your retirement accounts to cover 20% of your final salary (30% + 30% + 20% = 80%). That means we can use this information to calculate your retirement account withdrawal rate!
I’m going to bust out some algebra here, so stay with me. Remember that Income Replacement Rate (IRR) = Retirement Account Multiple (RAM) x Withdrawal Rate (WR).
Since we know the RAM is 10, and we know we only need an income replacement rate of 20%, we can plug in those variables to solve for WR. That will allow us to see exactly how much we will need to utilize from our retirement account each year to meet our needs, and whether it stays below a “safe” threshold. In this case, we see that an ultra-conservative withdrawal rate of 2% will be sufficient to bring us up to our 80% income target.
For those that want to see the actual numbers:
One thing that the above calculations show us is that, in this situation, you have some wiggle room. Let’s say you crunched the number and thought “that’s great, but I still want to withdraw 4% from my retirement accounts.”
Well, great. Now you’ve replaced 100% of your final salary! Given that you will no longer need to save for retirement, and you probably won’t being paying FICA taxes (the 6.2% Social Security tax and 1.45% Medicare tax that get taken out of wages), a 100% income replacement should result in a higher net income than when you were working!
Now you that you’ve done the math, you know you could pull out the extra money. If the market takes a dive or you want to pull back, you can get by on a 2% withdrawal rate. If things are going great and you feel like splurging a little, you can take the full 4% and still feel safe.
At the end of the day, any kind of retirement planning involves a lot of variables, and some amount of guessing (or “educated assumptions”). Using rules of thumb, such as the RAM, can provide you with some peace of mind. It will help you gauge if you’re on the right track for retirement or provide motivation if you’re not quite where you’d like to be.
The feedback you can get from rules of thumb can help you plan better, and you don’t even need a degree in finance to follow them!