Author: Evan T. Beach, CFP®, AWMA®
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My 4-year-old daughter loves working around the house to earn money. Perhaps we’re a bit early with these lessons. Nevertheless, when she earns money, it goes into an envelope with the words “baby doll” on it. One thing that kids understand that adults seem to have forgotten is that money itself has no intrinsic value; it is what it affords us that actually matters.
As adults, we tend to forget this until we face imminent transitions, such as buying a home, sending our kids to college, and the big one: retirement. When our portfolio gets hit by a big downturn, we start to question whether we can still afford the goal.
In the next few paragraphs, I’m going to teach you a five-minute exercise to see if you have (about) enough to retire. Note that there are lots of rules of thumb and assumptions in this exercise that may not apply to you. If you want this to be much more complicated, it can, and probably should be, if you’re going to decide to walk away from work. But, if you just want a spot check to see where you stand, this should do the job.
1. Figure out your expenses
If you make more than you spend, you have earned the luxury of not having to budget. Budgeting is not an exercise that people enjoy. Unlike your working years, budgeting in retirement is not optional. Pull out too little money and you’ve unintentionally paid for your kids’ country club memberships. Pull out too much and you’ll run out.
Here’s a simple trick: Look at two years of annual statements from your bank accounts. Divide the total debits by 24. That’s it. This is an accurate portrayal of your monthly expenses. This should encompass everything except what you pay for before it hits your bank account (taxes, health insurance premiums, group life insurance, etc.).
2. Gross up the monthly amount to account for taxes
It’s likely that the majority of your retirement savings will be taxed in some shape or form. Roth IRAs and municipal bonds are notable exceptions.
If your monthly expenses are $10,000 and your effective tax rate (how many cents you lose on the dollar to taxes) is 20%, divide $10,000/0.8, to arrive at $12,500 per month. That’s the gross amount you’ll need every month to end up with $10,000 in your bank account to cover your expenses.
3. Subtract Social Security and other fixed income streams
Let’s say that you and your spouse are receiving $5,000 per month from Social Security. This leaves a gap of $7,500 per month ($12,500-$5,000) that needs to come from somewhere else.
If you have a pension or annuity, subtract those figures out, too. Let’s say for this example there is a pension of $2,000 per month. Therefore, we need to take $5,500 per month from our investments.
4. Divide by 4%
The next, most important question is how much we need saved up in our investment account in order to be able to pull out that amount each month. The 4% “rule” has gotten more widespread attention in the last year as inflation has spiked and markets have tumbled, with folks wondering if it still works. There are lots of different retirement income strategies that, in my opinion, are more effective for withdrawing your savings. However, I have found nothing better that the 4% rule to quickly determine whether you are in the range of having enough money saved.
Using the numbers from step three, you’ll have to multiply $5,500 X 12 to get your annual shortfall amount: $66,000. Divide $66,000/0.04 (4%) and you’ll get $1,650,000. If this example is your exact situation and you have more than $1,650,000, you probably have enough. If you have much less, you’ll need to work longer, spend less or find some other way to stretch your savings.
5. Verify for your situation
As I have repeatedly pointed out, this is just a back-of-the-envelope framework. Here are a few of the major things that could throw it off:
- If you retire before you claim Social Security. In that situation, there is a gap between the income streams and the paychecks, which would cause a higher than 4% withdrawal rate in the early years.
- If you need long-term care late in life. This is a risk for almost everyone. It can be offset by insurance or by earmarked investments. Either way, it will create a need for more money.
- If you have a really low risk tolerance. Bill Bengen, who created the 4% framework, assumed a 50% stock/50% fixed income portfolio. If you’re not willing to have 50% of your money in stocks, you’ll likely have to withdraw less.
A financial plan is your road map. It will tell you if you have enough, (mostly) confirm that it will last, and point out any other gaps in your situation. It’s imperfect and life is always changing, so I would not walk away without a plan to confirm the numbers.