Retirement savers need to figure out how much money they need to accumulate and make sure that money lasts at least as long as they do. But first you need to answer another question. How much will you spend each year once you are retired?
Most retirement planning professionals recommend that you initially withdraw no more than 3 to 4 percent of your retirement assets to cover your first year’s living expenses. Each year after that you can increase your withdrawals enough to cover inflation’s bite, according to research by certified financial planners William Bengen and Larry Bierwirth.
The recent recession has made many of us wary of any standard rules of thumb when it comes to retirement planning. But we can rest easier knowing that this research data includes some pretty rough patches in history: several recessions, some extremely inflationary periods, and the 1929 stock market crash and Great Depression.
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What the research shows is that the safest initial withdrawal rate is 3 percent. There was no historical 50-year period during the 80 years studied where you would have outlived your money using a 3 percent withdrawal rate. And using a 4 percent withdrawal rate, your money would have lasted no less than 33 years.
Figure out how much you will spend. Unfortunately, none of this means anything to you if you have no idea how much you will be spending in retirement. Your first assignment is to figure out exactly what you want your retirement to look like. A good place to start is to examine your spending right now. Retirement may allow you to cut back in some areas, like commuting, work clothes, and lunches out. But other costs will probably increase, such as health care, entertainment, and perhaps travel. You need to estimate your retirement expenses. Do not use the shortcut of assuming some fixed percentage of your current income.
Calculate how much you need to save. Once you’ve nailed down your annual retirement budget, you’ll need to figure out how much of that will not be covered by sources such as Social Security, pensions, or annuities. Let’s call this your shortfall. You’re going to need to cover that shortfall with your own nest egg: 401(k) accounts, IRAs, and other personal savings accounts.
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That’s where all this research comes in handy. If you are retiring in your 60’s or 70’s and think you are likely to live 30 more years, you should be safe using a 4 percent withdrawal rate. That means you’ll need a nest egg of 25 times your annual shortfall. If you are retiring at a younger age, with up to 50 years in retirement, you’ll want to use the 3 percent rate to be safe. So, you will need a nest egg of 33 times your annual shortfall.
It’s worth noting that these studies were based on portfolios that included at least 50 percent stocks, the rest in bonds. If you want an allocation of less than 50 percent stocks, you’re going to need a bigger nest egg.
Can you retire with less? Maybe. The data shows that for most periods, 25 times your annual shortfall would have been enough to see you through 50 years of retirement. More recently, studies have shown that if you are willing to be a bit flexible in your annual spending, you might be able to get by with a smaller stash. This approach requires a little more vigilance on your part. You would need to withdraw less of your nest egg in lean years and return to higher levels when things perk up. But the payoff could mean an earlier escape from the rat race.
Sydney Lagier is a former certified public accountant. Since retiring in 2008 at the age of 44, she has been writing about the transition from productive member of society to gal of leisure at her blog, Retirement: A Full-Time Job.