One of the age old questions of financial planning is: How Much Money Do I Need to Retire? In the past, people commonly thought of having $1 million as being the appropriate amount to have for retirement. At the end of the day the answer is that it depends. The amount of money one needs to enter retirement is a completely individualistic determination. It is based partly on factors we can control, such as lifestyle preferences, and partly on factors that are out of our control, such as how long we will live. Because of this, it is important that each person discusses with a financial professional the relevant facts of their circumstances to help formulate what number is best for them.
However one looks at the retirement picture, it will primarily boil down to three key areas: how much time is spent in retirement, how much money is needed to live on each year in retirement, and the portfolio performance over time. We’ll explore each of these in more detail below.
Duration of Retirement
While the concept of retirement is wide-spread in today’s world, it is still a relatively new phenomenon in human history. Modern versions of retirement systems really started to come about in the late 1800’s and the idea of retirement filled with leisure activities was more or less firmed up in the US by the mid 1900’s. However, since that time period, life expectancies have grown while many at the same time push to retire earlier and earlier.
The result is that the time spent in retirement, and thus the amount of time your savings need to last, has grown drastically. Keep in mind when Social Security was initially created in the 1930’s, life expectancy in the US was 58 years old. As of 2019, US life expectancy had climbed to almost 79 years old. Many people commonly consider age 65 as the marker for the age of retiring. However, for those who can, they will typically retire even earlier. Many would love to be able to retire by 60, or 55, or even sooner if they can.
Thus, by retiring earlier and living longer, the average retiree needs to have funding available for even longer than in years past. This is a huge factor in deciding how much money is needed to fund retirement. All else equal, the longer you are retired, the more money you will need.
So, how can you gauge how long your funds need to last?
For better or worse, none of us has an exact insight into how long we will live. We essentially have to take cues from both our family history and society at large, make estimates, and allow some cushion with the idea that we are likely to be off. Family history is not a perfect indicator, but can provide clues as to your natural makeup and whether there are common health histories within your family. Do your family members tend to live longer? Do you have a history of heart disease? Are there other health histories that impact life expectancy in your family? This is a great place to start in thinking about your own likelihood. The other area we can examine is the typical life expectancy of the population at large. Keep in mind these are averages, and with all averages, some are higher and some are lower in practice.
It is also important to discuss this with a financial professional well versed in retirement planning. They will be able to help guide as to common ages for planning and ensuring enough cushion is there to do all you can to avoid running out of money prematurely.
All of this comes together to guide you in understanding how long you may be living in retirement, and thus, how many years of retirement you ultimately need to fund.
Living Expense Needs
The second area to think about in planning how much money you need for retirement is how much money you require to live on each year. This question ultimately boils down to the type of lifestyle you plan to live, and is different for each person.
You will need to think about how you will live your life even considering where you will live. The following considerations are just some of the things you will want to think through. Will you live in a high cost area or a low cost area? Do you own your home or will you be renting? Do you plan to travel? How might your expenses change as you age (perhaps more health expenses and less travel as time passes)?
Having a good idea of general living expenses is important as it directly drives the amount you will need to fund each year in retirement. While some work part-time during retirement to supplement their income, for most people, it becomes harder and harder to work as you age. Thus, you lose the ability to go out and generate more income. Planning ahead is key so you can try to avoid having to sacrifice your lifestyle in those final years.
Portfolio Performance
The amount of funds one needs entering retirement is also dependent on the level of risk one wants to take on and correspondingly the expected portfolio performance throughout retirement. For the accounts in which one controls the investment decisions and takes on the investment risk, portfolio performance will play into your retirement picture. From a basic standpoint, higher investment returns (better performance) makes achieving your financial goals easier. It means being able to save less to achieve the stated goal (with the rest coming through investment returns). However, all financial investments carry some level of risk. There is, generally speaking, a risk/reward tradeoff where higher reward (returns) are generally associated with a higher risk of loss. Therefore, it is extremely important to ensure that not only the returns of your investments, but also the risk of your investments is in alignment with your views and your goals. Please reference our article titled “How to Choose Your Investment Risk Profile” for a discussion about how to evaluate the type of risk you should consider in your portfolio. The key here is that better expected portfolio performance throughout retirement will lower the amount of savings needed at the onset of retirement (holding all other factors equal). Once you have targeted your risk tolerance, you can work with a financial professional to implement relevant investment strategies that will best help you work towards your financial goals.