The Retirement Success Equation
I see articles all the time asking if $1 million is enough to live on in retirement. I’ve also seen talk about whether $2 million is the new $1 million. Some even ask if saving $1,000 per month is enough.
The answer is yes… no… maybe?
These are not easy questions to answer because the inputs to the equation are very dependent on an individual’s current and future situation. One general guideline is you should have 25x your current salary saved by the time you retire. Another is you should withdraw only 4% of your assets each year in retirement. But these are only guidelines… rules of thumb… best guesses. A lot of guidance exists out there for these generalities, but not much information on the equations themselves. This is where the focus should be — not on an answer that fits the majority and doesn’t serve the individual very well.
The following equation has three parts that are explained below and can help determine whether you will outlive your money or not.
A Financially Successful Retirement = Assets + Income > Cashflow Needs
This looks pretty straightforward, and it can be, as long as you understand what each part includes, so let’s look at them one at a time. And keep in mind, the hardest part of this equation is making sure we are comparing apples to apples. If we are calculating the cash flow needs in today’s dollars, we need to make sure the assets and income are also calculated in today’s dollars. To put it another way, if milk costs $3 per gallon today, we want to make sure we have enough assets and income to cover the cost of milk when it is $7 per gallon in the future. This is present value versus future value.
Common Assumptions
To calculate your retirement equation, you will need to make two assumptions. You will carry these assumptions throughout the equation, and they will have a significant impact on the answers you’ll generate. So take your time figuring out what is best for your retirement goals. The two assumptions to figure out are: When are you going to retire, and when do you expect to die? The answers to these questions will help determine how many years you’ll need to plan for in retirement. Of course you don’t know exactly (especially that second one!), but you’ll need to come up with a best guess to move forward with a plan. If you tend to be more conservative, plan for an earlier retirement and longer lifespan, just to make sure you have enough.
Assets
The amount of assets is the factor that most individuals will need to solve for, and often, people turn to an advisor to help figure out. There can be a lot of moving parts with this input. How many assets do you have dedicated to retirement? Will your house be used to fund retirement? Do you anticipate any lump sum inheritance? Will you be selling a business? Because most individuals continue to fill their asset bucket until they retire, it’s easiest to determine the lump sum amount and work backwards to figure out how much to save on a monthly basis. This includes knowing an anticipated rate of return and inflation rate.
Income
For many, income might be a very simple determination because it would only include Social Security. From your Social Security statement, you can estimate the monthly benefit at a particular age and then calculate the anticipated income over your lifetime. Remember to include an estimated inflation rate in your calculation. Other types of income could be a pension, rental income, or deferred compensation payouts, just to name a few of the more common streams of income.
Cashflow Needs
Each section of the equation depends heavily on the other sections, and your cashflow needs are no exception. The reason it is impossible to answer whether $1 million is enough to retire is because we don’t know the answer to the cashflow question. You could calculate the amount of cashflow available each year with $1 million. A simple calculation could be $1 million divided by 30 years of retirement to get you a little over $33,000 per year, but is this enough? That is the real question.
To anticipate your cashflow needs, think about what you would like to do in retirement. Do you plan on taking any significant vacations? How many new cars do you think you will purchase? Do you plan on making any donations or gifts? How would you pay for a long-term care event? Calculate any large one-time or non-recurring expenses you can anticipate. Next, gather any expenses you have now that will end in retirement. Common examples might be mortgage payments or college education costs. An easy estimate might be taking your current cashflow needs, adding any anticipated one-time costs, and subtracting any expenses that will be ending. This will give you a rough estimate.
Calculating the Results
At this point, you should have the main inputs to calculate your equation. However, remember the earlier reference to an apples-to-apples comparison? It is very important to make sure all your inputs are either in the present value or the future value. We often tend to calculate the anticipated cashflow needs and the income amounts in the present value – in today’s dollars. However, we need to figure out the future assets needed so we can work backwards to the amount we need to save today. If you aren’t a fan of math, this is where one of the many retirement planning software programs or a trusted advisor can help.
Also, keep in mind: This is an estimate and not an exact calculation. The results of the calculation should give you a path to follow, but you should review it on an annual basis to make sure you are still on the same path. The market could change. Your income and lifestyle could change. Your anticipated retirement date or lifespan could change. All of these factors make it important to review annually and make adjustments along the way. This equation gives you the framework to calculate the most appropriate course for you and your goals, versus just a general guideline that serves the masses.
Unfortunately, when you start to dig into your retirement success, there isn’t a quick fix answer. It will take a bit of effort to gather this information and chart a course for your future. However, your future self will be very happy you took the time today to figure this out!
Anne M. Mank
Director of Financial Planning