Introduction
How much do I need to save to retire?
This is a question I revisit every few months. In the midst of the pandemic, government support might have persuaded companies to delay their layoff plans. However, such support will not last forever, and there are signs companies are either recommencing their retrenchment plans, or evaluating ways to pay different levels of wages to different workers performing the same job.
In this post, I will show you the common approaches to this question I have seen from the internet. I will then show you a simple approach I use myself, based on nothing more than a spreadsheet. I will also show you where you can go to find relevant data on which to base the assumptions you make in that spreadsheet.
Common approaches
The approaches to the question “How much you need to retire?” can be classified as follows:
Absolute number rule: You need $X million to retire!
The lure of this approach is that it is straightforward. You get a single number to your question that focuses your mind. An example of this is this article from CNBC. The number reported was US$1.7 million for US residents.
However, this approach has several problems. The first is it disregards cost-of-living differences, even within USA. The second is is that it is unclear if the US$1.7m is equally applicable to a FIRE devotee aged 35 years old, as to a Gen-X aged 65.
The X% percent rule
This is slightly more sophisticated than the absolute number rule. You first need to determine how much money you need to live on each year post-retirement. You then apply the X% to this amount to calculate how much you need to retire. Using the much propagated 4% Rule, and supposing you estimate you need US$50K each year post-retirement, the amount you need is simply:
Retirement Funds = Annual Expenditure / 4 percent
This gives US$1.25 million. Compared with the absolute number approach, this rule has the advantage of taking cost-of-living differences or life-style preferences into account.
An example of this approach is this article from BusinessInsider. Pay attention also to the link in the article that brings you to the criticisms of the rule.
Absolute number by retirement age and annual expense
This is a sophisticated implementation of a combination of the above approaches. The most sophisticated example I had come across is the following article on BusinessInsider. It uses Monte Carlo simulation, JPMorgan long-term return estimates used for investments, and a host of other assumptions to calculate the starting fund you would need to retire. I would read this to mean the model incorporates periods of stress in the financial markets. Such stress would cause the prices of financial assets to fall and shrink the pool of retirement assets. Most importantly, it takes into account which age you intend to retire, and what your desired level of expense is.
The problems with this approach are:
- typically, you get a choice of 2 or 3 levels of expenditure. In the BI article, the financial planner presented 2 levels of post-retirement spending: US$65K or US$100K.
- Presumably this covers the retiree and immediate family, but it is not entirely clear to me if that is the case. If so, would the planned amount be sufficient for 2 kids or 4?
- How long can the funds last? I presume the financial planner referred to the life expectancy of US residents in his projection. However, this is not clear, and there are differences between male and female life expectancy that doesn’t seem to have been accounted for in the results.
Retirement calculators
Other than the above rules of thumb, there are also a host retirement calculators available online. The general problem I find with these is that they require detailed information about your personal data. In this day and age, I would rather keep those to myself.
My 3-step approach
My 3-step approach to find out how much you need to retire can be summarized as follows:
- Estimate your projection period;
- Determine your desired level of expenditure;
- Calculate your starting assets.
The following sections cover each step in detail.
Step 1: Estimate your projection period
How many years you need to fund for retirement? There are 2 inputs to this. The first is straightforward: at what age you plan to retire. The second is life expectancy – when do you think your life will come to an end? This is slightly more challenging.
Fortunately, the US Government is here to help. Here you can find the US life expectancy table. From Table A, you can see that a 35-year old Hispanic male can expect to live another 45.8 years, and a 35-year old Black female for another 45.2 years. So if you’re planning to retire by 35 years old, your retirement fund should be sufficient to last you 45 years.
If you’re in the UK, the UK Government’s Office for National Statistics (ONS) has a Life Expectancy Calculator. Unfortunately, this has no breakdown by race. However, it does give you some idea of longevity risks. That is, what are the chances you might live beyond the life expectancy?
For example, a 35-year old Male with life expectancy of 85 years has a 1-in-4 chance of living to 94 years old, and 1-in-10 chance of living to 99 years old. So if you only plan for a retirement pot to last you till age 85, and you ended up living to 94 or 99, you would be in a pickle.
In my spreadsheet, I created 3 columns, using the example of a male who is 35-year-old in 2020. The first column is Age, starting with the desired retirement age. The second column is the Retirement Year Number, starting with zero at the retirement age. The third column is the calendar year, for easy reference.
To cater to longevity risks, I extend the projection all the way to age 99. You can see that he would be in his 64th year in retirement by then, in calendar year 2084.
Step 2: Desired level of expenditure
Instead of arbitrarily deciding you need US$65K or US$100K, you can actually refer to your own personal circumstances. You can look at your own expense pattern, and incorporate dependents into the projection.
You can also refer to national statistics to determine how realistic are your expense assumptions. The US Bureau of Labour Statistics (BLS), for example, has a very comprehensive Consumer Expenditure Report. Other than showing how much Americans spend on average in a year, it also shows the breakdown of where they spend it on. I find the breakdown categories very useful. It acts as a checklist to make sure you don’t miss out accounting for important items.
The most useful table I find, however, is Table 2 in at the end of the report. This shows the average annual expenditure patterns by income deciles. Other than spending different amounts of money, those in the top 10% of income also spend very differently than those in the bottom 10%.
Similar tables can be found in the UK ONS website and the Australian Bureau of Statistics.
Continuing with my spreadsheet example, I assume the 35-year old male has a consumer unit in the Sixth 10 percent. You can see that this consumer unit has 2.5 people, spending a total of US$54,223 per annum, or US$21,689 per person per year.
Instead of using the Sixth 10-percent, you can use other deciles as you deem fit.
Inflation
The Consumer Report above is based on data in 2018. Since then, consumer price level has changed. On another section of the BLS website you can see the inflation rates for the past few decades. Applying 2.3% inflation to 2019, and 0.6% for 2020 year to date, I have the following:
The per-person annual expenditure is US$22,321 in 2020, adjusting for inflation. Assuming this 35-year-old male has 3 persons in the household, instead of the statistical average of 2.5, we have an annual household expenditure of US$66,964. Let’s say this third person is a dependent child.
I use an inflation rate of 3% to project the annual household expenditure out into the future. I also assume in 10 years’ time, the household size will be reduced to 2, as the child becomes financially independent. We further assume the man’s spouse lives as long as he does, so the household size remains at 2 for the projection period.
Extending this projection all the way to age 99, we have the following:
You can see the power of inflation here. An inflation rate of 3% will compound our household expenditure of US$67K in 2020 to US$196K in 50 years time, US$255K in 59 years time and almost US$300K in 64 years time.
The sum total of household expenditure are:
- US$5.5m to age 85;
- US$7.6m to age 94; and
- US$9.0m to age 99.
So even if you’re only aspiring to live a life-style in the sixth 10-percent of all US households. You would still need to plan for a total expenditure of US$5.5m to US$9m, depending on how long you live.
Instead of using 3% inflation, you can assume other rates as you deem fit.
Step 3: Calculate your starting assets
The total expenditure, however, is not the same as your retirement funds at the start of retirement. This reason is that your retirement assets should earn some form of return. The rate of return is increasingly squeezed, however. This is because central banks flood the financial markets with liquidity, and asset returns get depressed. In the JP Morgan long-term assumptions mentioned above, US large-cap equities have long-term return projections of 5.25% p.a. in 2019. This is a far cry from the 8% return assumptions many pension funds have been using.
For simplicity, I assume that the 35-year old man invests equally in fixed income and equities. That is 50% of his portfolio is in fixed income and 50% equities. The fixed income allocation is invested in US long-term treasuries, which JP Morgan’s long-term assumptions estimate at 3.25%p.a. For conservatism, I use 5% for equities return and 3% for fixed income returns. This gives an annual portfolio return of 4%. I also assume the assets produce an annual income of 2% of assets. To cater to the increasing frequency of black-swan events, I assume the equities portfolio declines by 50% every 7 years. This results in a portfolio decline of 25%.
To assess the viability of the above assumptions, check out my previous post about the 7 ETFs retail investors need post the pandemic.
Supposing the man starts off with US$1 million. This is how the projection would look like. At year 0, this produces an income of US$20K. It also appreciates by 4% or US$40K. However, the total is still insufficient to meet the household expenditure of US$67K. This will need to be funded by the asset pool, which reduces by US$7K. After 17 years of retirement, at age 52, the man will find he has run out of funds.
To ensure he has sufficient funds, the End-of-Year asset must be greater than zero at age 85. This can be achieved if he starts with US$3.2m. This can be solved using the Goal-seek function in your spreadsheet program.
To ensure he can withstand the 1-in-4 or 1-in-10 longevity risk, the starting pot needs to be US$4.1m and US$4.6m respectively.
I had made a few assumptions that you can alter as you deem fit:
- 3% fixed income return and 5% equities return: if you think these are too aggressive or conservative, you can always change these to other values if you believe those to be more reflective of future rates of returns;
- 50-50 allocation: you can amend it to, for example, the 60-40 that is commonly used, with 60% of allocation going to equities;
- 25% hit to portfolio value every 7 years: if you think this is too conservative, you can amend it to 15% hit every 7 years, or 25% hit every 10 years, or any other combinations.
Conclusion
So how much do you need to retire? In order to retire at age 35, you will need
- US$3.2m to fund a total household expenditure of US$5.5m to age 85;
- US$4.1m to fund household expenditure of US$7.6m to age 94; and
- US$ 4.6m to fund household expenditure of US$9.0m to age 99.
I hope you find useful the above 3-steps approach to finding how much you need to retire! Leave a comment to share your thoughts!
