How is your nest egg coming along? It’s difficult to know if you haven’t calculated how much you will need to retire. Here are three steps to quickly establish how big your nest egg needs to be.
1. Estimate your withdrawal rate. A 3.5 percent annual withdrawal rate is a conservative estimate that should be acceptable for a quick assessment. The lower your annual withdraw rate, the less risk you take that you will outlive your assets in retirement.
2. Approximate your annual expenses. Start with an estimate of what you spend annually today and you may want to factor in major changes during retirement. For example, you may want to travel more in retirement or downsize or expand your home. Anticipate any major purchases in the years ahead.
3. Compute your retirement number. Take your annual expenses estimate and divide that number by your annual withdrawal rate to determine a rough approximate of the amount you need in your nest egg. For example, if your current estimated annual living expenses are $70,000 and you plan to withdraw 3.5 percent of your savings each year you want to have $2 million in properly diversified assets. This exercise is before the effects of inflation, so assume everything is in today’s dollars.
[Annual expenses] / [Annual Withdraw Rate] = [Amount You Need in Your Nest Egg]
If your nest egg is close to or exceeds your estimated need you’re well ahead of most Americans. But don’t plan your retirement party just yet. Your next step should be to perform a more detailed analysis of your retirement situation and assess how comfortable you are with your nest egg’s ability to cover your future expenses.
Don’t panic if you can’t see how you’ll ever get your nest egg big enough. Social Security and defined benefit pensions are designed to offer you additional relief in terms of covering some of your annual expenses after a certain age.
For those who haven’t started planning for retirement, this retirement number may be just what you need to get you motivated to start putting a more detailed plan together. Your plan could identify how you can both grow your nest egg and reduce your anticipated annual expenses in retirement. For example, for every $1,000 you are able to reduce your retirement expenses you could shave around $28,500 off the amount you need to save depending on your annual withdrawal rate.
A retirement number may evolve over time as your needs change and after the affects of inflation. You’ll want to revisit your retirement number periodically to make sure it is still a relevant retirement goal for you.
Brian Jaeger is the author of 2million's Personal Finance Blog. For the past 5 years Brian has chronicled his journey to reach his financial freedom goal of a $2 million net worth.