Legg Mason posed the question “how much do you need for retirement?” to a group of “mass affluent” investors (aged 40 – 75 with more than $200,000 in investable assets). Those surveyed said they would need at least $2.5 million to maintain their current standard of living. According to the Government Accountability Office (GAO), households aged 55-64 have saved on average only $104,000 for retirement, and households aged 65 – 74 have average retirement savings of just $148,000.
Another study, this one by the Insured Retirement Institute, reported that of those surveyed, only six in 10 Boomers (aged 52 – 68) have saved money for retirement. Only 27% of Boomers reported in 2015 feeling extremely or very confident they will have enough money to last throughout retirement. Twenty-four percent of the Boomers surveyed had, within the prior 12 months, postponed plans to retire. Yet, four out of 10 Boomers with less than $250,000 in retirement savings said they believed they would be able to pay for basic needs and medical expenses in retirement, and maybe even have some left for travel and leisure—probably not a realistic assessment of their retirement readiness.
A 2015 Retirement Readiness Survey by Aegon Center for Longevity and Retirement reported there is a “serious disconnect” between the retirement lifestyles envisioned by those surveyed, and their actual savings behavior. While the vast majority (87%) reported feeling personally responsible for having accumulated sufficient savings for retirement and 77% were aware of the need to plan financially for retirement, only 21% had a formal written retirement strategy and nearly a third (31%) had none at all.
The Center for Retirement Research reports that about half of working-age households are not saving enough to maintain their pre-retirement standard of living in retirement. Higher income households should plan to provide at least half of their retirement income from their personal retirement savings (401k’s, 403b’s, IRA’s). Depending on how much will be generated from Social Security and other sources (pension plans, income from real estate, inheritance, etc.), the portion that needs to be funded by personal retirement accounts could be significantly more. To produce this income, the typical household needs to have been saving about 15 % of annual gross earnings during their entire work life, which is well above today’s actual saving rates for most households.
How much you will need in your retirement account(s) is a very personal question. There is no one magic number or rule of thumb. It depends entirely on what your estimated income and expenses will be. Given the dramatic increase in life expectancies, the retirement account will probably need to last for 30 years or more. Also, the effects of inflation are significant and must be factored in.
There are two ways to calculate the amount of money needed in retirement: the capital utilization method, which assumes all retirement assets will be gradually liquidated during the course of retirement (in other words, you end up with $0 at the end); and the capital preservation method, which assumes the retiree(s) will live off the earnings generated by the investment portfolio. Our experience tells us that most people who have worked hard to build retirement savings will not want to risk running out of money in retirement if they outlive their estimated life expectancy. Also, not depleting the account provides optionality to cover long-term care and other expenses that rise in retirement. Last, many savers would like to have funds remaining to pass on as inheritance or charitable contributions. Therefore, we’ll focus on retirement planning using the capital preservation method.
For purposes of illustrating the thought process behind retirement planning, we’ll use as an example a married couple—Bob and Sue—currently 58 years of age. The couple currently earns an annual household gross income of $150,000. They plan to retire in 10 years. They estimate that they will be able to maintain their standard of living if they are able to generate 75% of their current gross annual income in retirement. Thus they estimate that in their first year of retirement, they will need $112,500 (75% of $150,000) in today’s dollars. They also assume that social security will cover $31,956 of this amount. Thus the amount of income needed from their retirement assets in the first year of retirement 10 years out is $80,544. This figure, however, is in today’s dollars so it must be adjusted for inflation. The assumed rate of inflation is 2%. They also assume that their investments will produce net-of fee annualized returns of 6%.
Step 1: Calculate the inflation-adjusted income required from Bob and Sue’s retirement assets in 10 years. At an annual inflation rate of 2%, $80,544 in today’s dollars will equal $98,183 in 10 years. Thus, in the first year of retirement, Bob and Sue estimate they will need $98,183 in income from their retirement account.
Step 2: Calculate the amount that is needed in Bob and Sue’s retirement account to generate $98,183 in the first year of retirement, and to generate in each subsequent year an inflation-adjusted income that sustains their purchasing power. Because Bob and Sue want to maintain the equivalent purchasing power as their starting income 10 years from now, an inflation-adjusted rate of return must be used to calculate the principal that is required. In our illustration, annualized returns are assumed to be 6% and inflation is 2%. The inflation-adjusted rate of return is therefore 3.92%. To know how much the retirement account must be worth to generate $98,183 in the first year of retirement 10 years from now, and generate comparable inflation-adjusted income in each subsequent year, divide $98,183 by 3.92%. The answer is $2,504,668, remarkably close to the number estimated by the well-off investors surveyed by Legg Mason.
What are the key takeaways from this brief illustration?
1. Managing expenses in retirement is a top priority. We have far more control over our expenses than our income. The closer we get to retirement, the more granular we need to be in identifying and quantifying all expenses so that we can make adjustments on the spending side as needed. Spending needs to be in line with the income that our retirement account and other sources generate.
2. Identify all sources of income: Whatever is not covered by “other sources” must be covered by your retirement savings, so make sure to identify all potential sources of income such as social security and pensions. Log on to the official Social Security web site (www.ssa.gov) and find out what your estimated monthly income from Social Security will be. Your income analysis may lead you to see the benefit of continuing to work part-time even after you’ve retired from full time employment.
3. Account for inflation: The dollars you will need 10, 20, 30 years from now to buy what you are used to buying today will be significantly greater because of inflation. In calculating your projected required annual income in retirement, you need to increase that amount annually by the rate of inflation. To calculate the principal you will need to generate inflation- adjusted income, you must use inflation-adjusted return assumptions.
4. Understand the difference between capital utilization and capital preservation: In the illustration, we saw that because Bob and Sue wanted to preserve their retirement account and live solely off the income, they required retirement assets of $2,504,668. Using the capital utilization method and an assumed life expectancy of 27 years, the amount they would need in their retirement account would be considerably less. The capital utilization method assumes you will use up your account by the end of whatever number of years you assume as your life expectancy. If Bob and Sue planned to spend their retirement account down to $0 in 27 years, they would only need $1,617,770. Of course, the big risk in planning to spend all your money before you die is that you may live longer than you expected, or you may have higher expenses than planned so the account may not last as long as you estimated.
5. Make a plan: Go through the analysis we’ve just described, no matter where you are in your savings and no matter how far you are from retirement. It is so much better to have a realistic picture of your retirement readiness so you can address how to resolve potential issues such as the need to save more in the accumulation phase and/or to reduce spending or increase income in the distribution phase. Without visibility of the facts, it’s hard to take control and respond appropriately.