In determining how much money you’ll need for retirement, the standard advice is to determine how much money you’ll need for yearly expenses, then look at the amount of money that your savings can generate and make the two match. Ideally you don’t want to be spending your nest egg as you age, except maybe near the end of your life where you won’t soon need the money anyway. Instead, you want your nest egg to be generating income for you to use for daily expenses so that the amount of money your have to generate income never declines. You also want your account balance to grow with time so that the income you are receiving can keep up with inflation. Otherwise, your spending power will decline as you age, perhaps leaving you without enough income to make ends meet when you are into your eighties or maybe even your seventies.
There are different ways of generating income. One way is to give your nest egg to an insurance company in exchange for an annuity. The annuity will then pay you a prescribed amount based on the terms of the annuity. Many people like the idea of an annuity because it takes some of the decisions, such as how to manage risk while still generating enough income, out of your hands. Ideally you will simply receive a check periodically from the annuity without needing to worry about how the money is invested or how long you will live since the insurance company takes care of those issues. You must realize, however, that most people will do better financially investing money outside of an annuity, assuming that they know how to invest or have a good financial advisor to invest for them. This is because in buying an annuity, you are essentially paying for an insurance policy to cover the risk of living longer than the average person, making the insurance company send checks for a long period of time. You see, the insurance company looks at actuary tables (tables predicting how long people, on average, will live and be collecting checks) and sets the amount they pay out to be the amount they can generate from the money they receive divided by the average life expectancy, minus their expenses and a profit. So those who live an average amount of time receive less. Those that die early really get less than their money’s worth. Those who live a very long time may make more than they put in, receiving some of the money from those who died early.
If you are comfortable investing for yourself or if you have a good financial advisor, you will do a lot better simply investing the money than you will in buying an annuity. A rule-of-thumb is that you can spend about 4% of your net worth each year without your net worth or your purchasing power declining. This assumes that the money is properly invested to generate the income that is being spent and also grow to make up for inflation, meaning it is properly spread among income generating assets like bonds and real estate and assets that grow in value like common stocks. Note also that this is just an estimate – it is safer to spend less, perhaps 3%, and sometimes you can get away with spending more.
Using the 4% rule, the amount you need to have saved in retirement is twenty-five times your needed annual income:
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The savings goal derived from the 4% rule, however, should be the bare minimum you should build up for retirement. I would target at least double this amount. The reason is that increasing your savings increases your potential income, and not just by a proportional amount. If you double your savings, you might have four times as much income to spend in retirement while also reducing the risk that you will run out of money. The reason is that those who have more money than they absolutely need to generate income are able to take more risks, and therefore generate a lot more income than those who have saved just enough or not enough.
For example, let’s say that you need $30,000 per year to keep the lights on, provide food, and pay for your prescriptions and doctor’s visits. If you save up a million dollars, you would probably be able to buy an annuity that would pay you the $30,000 annually for the rest of your life. When you died, the insurance company might keep the rest of the money you invested or they might return a portion, depending on the terms of the annuity. You could also invest yourself and just get by if you had saved up $750,000. You would need to be very conservative in your investing because an event like the 2008 stock market crash could cut your income down significantly.
If you had $2 million saved, however, you could still buy an annuity for $1 million or invest $500,000 to generate the needed income, but you could then invest the remaining money fully in stocks. In years where the stock market portfolio did well, you could use some of the capital gains to buy a larger annuity or add to the amount of money you had invested for income. The remainder could be reinvested to allow for even larger capital gains in the future. In years where the market does poorly, you could just use the income from the annuity or the income portfolio for expenses and leave your equity investments untouched and wait for the market to recover.
Over twenty years of retirement the original $2 million could easily grow into $4 million or even $8 million. Maybe you could buy a million dollar vacation home in your seventies or take a nice trip every few years using the extra income. Maybe you could pay for college for your grandchildren or start a family trust to pay for college for future generations. This is as opposed to just barely getting by through retirement.
In summary, when deciding how much to save for retirement, target more than you need because that will allow you to take more risks and generate a much bigger income. You’ll also reduce the risk that you might outlive your money.
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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.