I came up with this answer after reading the article, 4 Steps to Quickly Figure Out Your Retirement Number in Yahoo Finance by Trent Hamm(Link here: http://finance.yahoo.com/news/4-steps-quickly-figure-retirement-185751996.html).
Note that this is not based on Mr. Hamm’s article. I discovered quickly that Mr. Hamm’s method was not quick. His steps are:
1) Figure out what your current salary will look like at retirement.
2) Use Google to figure out what 1.03 raised to the power of the number of years you’ll be retired.
3) Go to your Social Security statement and subtract your annual Social Security benefit from the number.
4) Multiply that number by 20.
To complete step 1, you’ll need to predict the future and figure out what you’ll be making 20 or more years from now. (For those who have less than 20 years who are just now figuring out what they need for retirement, that answer is “everything you can possibly save”.) As one commentor pointed out, this is really immaterial anyway. It doesn’t matter how much you’ll be making before you retrie. It’s how much you’ll be spending in retirement that matters.
Step 2 predicts a 3% inflation rate in retirement. We have gotten used to 3% inflation, which might be near the longterm average, but there is nothing to stop inflation from being much, much higher over short periods of time. If you had retired just as the 1970’s got started and assumed a 3% inflation rate, you’d be hurting in 1979 when inflation was in the high teens (of course, wait for Paul Volker to raise rates in the early 1980’s, and you’d be making 18% on your CD’s). I think you really want to have enough saved to allow you to put a good protion in equities, which will track inflation over long periods of time, rather than assume you’ll have it in cash or annuities and hope inflation remains tame.
Step 3 involves pulling out your Social Security statement. Mine typically goes staraight into the burn pile since I know it is nothing like a bank statement or a mutual fund statement. It is simply a calculation based on what the current laws are, but there is absolutely nothing that requires the benefit to continue to be paid. Given that the national debt is $17 T and set to top $20T in the next couple of years, and given that if you include all of the liabilities in the debt number it would equal $1.1 M per taxpayer, I wouldn’t expect to receive anything from Social Security. I therefore wouldn’t even include it in my calculations.
Step 4, multiply by 20, assumes that you will be taking out 5% each year, which is near the number the financial planner estimate you can take out with a fairly low chance of outliving your money. They are starting to lower this number to 4% or even 3% as people are living longer, so this may not be conservative enough. Then again, I’m not planning to make my children millionaires when I retire, so maybe it’s better to plan and stiff the undertaker.
So, if I didn’t use this method, how did I come up with $8,734,880.36 as the exact retirement number for the readers of The Small Investor? Well, I say you need about $10 M. No matter your income level, I think $10 M, which would provide an annual return of about $500,000 if you withdrew 5% per year, would be enough for any of my readers to live comfortably (I don’t think that many people who blow through a million dollars a month are reading), particularly if they’ve paid everything off and now just need moey for food, healthcare, travel, and hobbies.
In fact I think most could probably live on $50,000 and be happy, so $10 M shoud provide plenty of money from which to draw an income and have a good portion still invested in equities for inflation protection. Sure, you could see another 40% drop in the market as in 2008, but assuming you had $1 M of that money in fixed equities, that would still leavel about $6.5 M, which is still plenty of money from which to draw a $50,000 income.
So, starting with this $10 M figure, I started plugging in numbers into the interest calculator at Bankrate.com. Assuming one started with $500 and invested $500 each month over a 50-year working lifetime, and assuming a rate of return of 10% (which is near the long term market average of 12.5%, minus 2.5% to account for longterm inflation) one would amass $8,734,880.36, which is kind-of-close to $10 M.
My point here is that you shouldn’t be calculating a retirement number and planning to reach that goal starting from the time your’ 45 or 50. You should be putting away 10-15% of your income each month starting from the time you are in your first job so that you’ll have far more than you need by the time that you are ready to retire. If you save just the bare minimum, you’ll need to invest very conservatively because you won’t be able to tolerate a market event like 2008, which means you’ll have far less return and be in danger of having inflation wipe your savings out. You’ll also be worrying about your money lasting, which isn’t what you should be doing in retirement.
So instead of worrying about numbers, just put $500 away each month religously, or 15% of your paycheck if $500 is too much. There’s no reason to darg out your Social Security statement or do all sorts of financial prestidigitation. Retirement age will be here soon enough.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.