Nowadays, somebody only need to write “The” and “Number” next to each other and we automatically know what it means: the amount that you need in your nest-egg so that you can finally throw off those corporate shackles and ‘retire’ …
… well, do anything other than ‘work’ for your daily crust.
The only problem is that nobody tells you how to find The Number!
I should know, I read books on the subject and they all focus on rubbish like: “multiply 75% of your pre-retirement’ salary by 13”.
Which has some obvious problems:
1. How do I know what my pre-retirement salary will be?
2. What if I spend more/less in retirement than when I was working?
3. How will I know my money will last?
The reality is that – for most people – there is (and should be) a total disconnect between how you make your fortune and how you spend it!
In other words, just because you earn $x before you retire, it doesn’t mean that you will spend 75% of $x to 125% of $x (as most financial authors assume) in retirement.
So, I came with my own method – and, it worked for me!
1. Complete a simple spreadsheet of your major (non-investment) personal purchases, income, and living expenses now and over the next 1, 5, 10, and 20 years. Don’t forget to apply the Inflation Adjustment Factors!
2. To help I have listed the typical expenditures of a $100,000 a year lifestyle, a $250,000 a year lifestyle, and a $550,000 a year lifestyle. These should provide some reference points to calculate your own future living expenses.
3. Use the spreadsheet to calculate Your Number and Your Date.
… and, I’m betting that it won’t even resemble your expected final salary – in fact, I’m betting that the number is so damn big’n’scary that you won’t even get there just on any typical salary – even with your 401k maxed 😉
I agree with your analysis.
The way I did it was a bit more involved, but essentially the same. I figured out how much I needed if I wanted to retire today (assuming a 4% withdrawal rate while investing in a relatively conservative 60/40 stock/bond split during retirement). Then, I projected that number out over several years (or decades) to take inflation into account.
This gave me multiple numbers and dates to choose from, each requiring a different investment rate of return (based on the amount you currently have invested and your monthly/annual contributions). I selected a range of numbers and dates that I felt were obtainable given my selected investment strategy–and then reapply the process every couple of years.
It was suprising to see that if you simply waited a couple of extra years, how fast the required RoR drops–allowing for a wider range of investment options.
@ Jeff – That’s why we use the MINIMUM Number and LATEST Date that we would be reasonably satisfied with … we need to keep the required Annual Compound Growth rate as low as our Number/Date truly allows us to.
Now, if you want to get really scared, try using a Monte Carlo Simulation: http://www3.troweprice.com/ric/ric/public/ric.do
@AJC – All of my numbers are minimums, just adjusted for inflation. For instance, if I need $10M today, I’ll need 10.4M in a year, and 18M in 15 years just to have the same standard of living (assuming 4% inflation). From what I understand, your analysis is the same, but you select one (maximum) time period, adjust the number for inflation, and then calculate the annualized required return based on the adjusted number and time period. I just do it for multiple time periods.
Interesting calculator, it has some major flaws, but utilizing 1000 monte carlo simulations to determine expected market results is always a good idea. The books “Four Pillars of Investing” and “The Intelligent Asset Allocator” have a good analysis of a maximum withdraw rate (turns out to be 4%) that allows you to have your money last forever without a reduction in standard of living (assuming worst case scenerio market conditions over a 30 year period with various asset allocations).
@ Jeff – 2.5%; 4%; 5%; 6.6%; 7% these are all ‘well justified’ numbers that I have seen quoted by various ‘experts’ citing various ‘scientifically rigorous studies’ … scary isn’t it (?!) especially when you realize that we are talking about the difference between living off, say, $25,000 / $40,000 / $50,000 / $66000 / or even $70,000 a year off the ‘same’ $1,000,000 … estimate wrong on the one side and you may be tightening your belt unnecessarily …. err wrong the other way and you could find yourself out of money. Seems to me this is one subject that we need to explore a LOT more deeply …
@AJC – I agree…this subject should be discussed further, as it is essential to determining an accurate Number. 4% might or might not be the right withdraw rate (I didn’t mean to sound so absolutist above).
For me, any withdraw rate that I would consider must be conservative (low) enough to allow periodic withdrawals forever. A lot of the higher withdrawal rates I’ve seen either deplete the nest egg to 0 over a fixed period (usually 30 years), have optimistic expected investment returns, or underestimate the effect of investment risk (variance in return).
The general rule (as I understand it) is to find a real return of an investment by removing the inflationary component from the expected long term (systemic) return of your selected investment. You can safely withdraw a portion of the real return, with the remaining portion be used as a cushion for the eventual downturns of the investment. For instance, if you have a diversified equity/bond portfolio that has a 10% annualized expected return, assuming 4% annual inflation, you should be able to withdraw up to 6% annually forever (depending on how you calculate your cushion). Plus, because your nest egg grows at least as much as inflation (because you don’t withdraw the inflationary and cushion components), in theory, you should be able to keep the same standard of living forever.
@ Jeff – This is true, but the problem is in the AVERAGES … so the x% withdrawal rate that you do select is supposed to compensate you for the ‘typical’ variance from the average that the underlying investment has. So, there are various approaches: worst case; +/- 1 or 2 Standard Deviations; Monte Carlo Analysis; and so on …
Because of this, there can be no ‘right’ answer … you have to select a level of variation that you are happy to live [pun intended] with.
And, you will find that almost none of these methods allow for an a variation in inflation rate e.g. you may be able to select, say 4%, but then you have to assume it will remain at 4% for the entire, say, 30 year period … ooops! Very unlikely 😉
I haven’t written a post on this yet because it requires a LOT of analysis before I will be happy making a recommendation.
For now, I have settled on the Rule of 20 (i.e. 5%) for calculating Your Number, but I actually plan for a 2.5% to 3.5% withdrawal rate in my personal spending.