How Much Retirement Savings Do You Need?

Last Updated Feb 8, 2010 1:23 PM EST

Only half of workers have estimated how big their retirement nest egg should be.  Have you?
"I've got a $300,000 nest egg in my 401(k) plan. I have all the money I need to retire."
I often hear statements like this at my retirement-planning workshops, at cocktail parties, and from my clients. I always respond, "From your retirement savings of $300,000, how much do you need to withdraw each year to cover your living expenses?"

"I dunno. I'll just take out what I need. Three hundred grand is a lot of money -- I guess it should last."

Guessing isn't good retirement planning! But occasionally I get an answer like this:

"About $30,000 per year."
These people are often surprised to hear me say, "If you spend $30,000 each year, after 10 years, most likely your $300,000 nest egg will be gone. Then you either need to die or go back to work."

"Huh? What about the power of compound interest?"
"Sorry, you'll need more money to last for your lifetime. Compound interest isn't magic, and it won't bail you out."

Simple Targets for a Retirement Nest Egg
So how much money do you need to retire comfortably? People want a neat and tidy number or formula; unfortunately, not much in life is neat and tidy, particularly when it comes to retirement planning.

If you're thinking about retiring soon, at the very least, you should get into the ballpark with respect to how much retirement savings you'll need. The simplest way is to use some rough rules of thumb. Suppose you need a given amount of annual retirement income to supplement Social Security, pensions, and wages (if you work in your retirement years). To estimate the retirement savings needed to generate this income, multiply your required annual income by:
  • 20 if you're retiring in your mid to late 60s or later
  • 25 if you're retiring in your late 50s or early 60s
  • 33 if you want to be virtually certain you don't outlive your assets and you want to leave money to children or charities when you're gone
For instance, suppose you need to generate a pre-tax annual retirement income of $20,000, in addition to your other retirement income. You'll need retirement savings of:
  • $400,000 using the 20 multiplier
  • $500,000 using the 25 multiplier
  • $660,000 using the 33 multiplier
The best use for these targets is if you're considering retiring soon and want to see if your resources are in the ballpark. If you're well before retirement, you can also use them as savings targets for your desired retirement age, but you should adjust them upwards for expected inflation between now and then.

Retirement Nest Egg Targets: Looking Under the Hood
What's behind these multipliers? The retirement savings targets are intended to generate a lifetime retirement income that has a low chance of outliving your assets and increases for inflation each year. I used actuarial and financial wisdom regarding prudent draw down percentages and flipped them around. This wisdom suggests withdrawing 4 percent or 5 percent of beginning assets (depending on your age at retirement) and giving yourself increases for inflation each year. These draw down percentages have roughly a one in 10 chance of outliving your assets (you can find detailed analyses and examples in my book Live Long & Prosper! Invest in Your Happiness, Health and Wealth for Retirement and Beyond). Flipping (or inverting) 4 percent and 5 percent results in multipliers of 25 and 20.

The multiplier of 33 assumes you want to live on just the interest and dividends of a portfolio balanced between stocks and bonds, and leave the principal to children or charities. This assumes your investment income return will be about 3 percent per year, and flipping this percentage results in a multiplier of 33.

As you can see, these are rough techniques that are just intended to get you started. It's really better to use retirement planning software or work with a financial planner to refine your planning.

Using rough estimates, however, is better than doing nothing; at least they get you in the ballpark of having enough money to generate a reliable source of lifetime retirement income. Also, it's important to realize that more refined analyses require you to make assumptions about your lifespan, spending needs, and the economy for a few decades. These assumptions can easily be blown up by unexpected events. Using rough rules of thumb might be the best you can do. And, be willing to make adjustments in your plans as your rest-of-life unfolds. You'll see similar good rules of thumb in Carla Fried's excellent post 30-10-4 Formula Key to Retirement Success.

I'm reminded of the adage "nobody plans to fail, but many fail to plan." Having a good plan gives you the confidence to enjoy a healthy, meaningful rest-of-life. Surveys show that only about half of older workers prepare a financial analysis to determine the size of their retirement nest egg. Are you in this smart half, and if yes, how do you prepare your analyses?

Image from iStockphoto contributor leventince
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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.