How much money do I need for retirement?

When talking about retirement and financial independence planning, that is by far the most often asked question I receive from clients, friends, and family members. My guess is that most financial planners in the Loveland area address this topic – more than any other – with their clients. 

The answer to that question is…it depends.

Depends on what?

The amount of money you need for retirement depends on what you envision for your retirement and the number of years you plan to enjoy in retirement.

According to Motley Fool, only one-third of Americans are confident that they’ll have enough money to live comfortably in retirement – and that some of us may be overconfident because we overestimate our years of employment earnings and underestimate our annual expenses in retirement.

For the balance of this post, I’m going to use the terms “retirement” and “financial independence” interchangeably.

In order to retire, we must attain financial independence – but not everyone who is financially independent is retired.

Where to start to answer the financial independence question?

Start where you’re standing today and envision what your life would look like if you were now, today, financially independent. For most of us, it would look pretty much the same – with the possible exception of no employer, additional travel, more daily leisure time. Very few people adopt a radically different lifestyle once they reach financial independence. They simply do more of what they enjoy and less of what they don’t.

That leads us to the next step – figuring out the amount of money we currently spend on life and then subtracting out those expenses that will go away by the time we reach financial independence. The absence of a mortgage payment is probably the single largest expense the majority of retirees can plan for.

Let’s use the fictitious couple of Henry and Penelope Watson to illustrate the plan for retirement savings.

The Watson’s enjoy a comfortable lifestyle which costs them $7,000 per month. That amount includes a mortgage payment of $1,700. It does not include medical insurance premiums or income taxes, which are withheld by their respective employers.

Henry and Penelope want to maintain their current lifestyle when they reach financial independence. They plan to do some travel in the US and perhaps an international trip every few years. They plan to pay off their mortgage within the next few years – prior to retirement.

Here’s where we start crunching the numbers and applying some time value of money principles.

The first step is to determine the inflation-adjusted cost of living for the Watsons when they reach financial independence in 12 years. I use a physical financial calculator (HP 10bII+). It also downloadable at www.educalc.net and available as an app on smart phones.

If we assume an average inflation rate of 3% over the next 12 years, the amount of money that is required to purchase $5,300 worth of goods and services in today’s dollars (mortgage is paid off) is $7,557 – when the Watsons retire.

If we use a life expectancy of 100 years (better to run out of life before running out of money) and the Watsons plan to retire at 67, then we want to plan for 33 years of financial independence.

The next calculation is a bit more complex than the first – we need to adjust for the average return on investment in their retirement accounts and also adjust for inflation so that Henry and Penelope don’t lose purchasing power as they age.

Not factoring in for the additional costs of medical care and taxes on retirement account withdrawals (too much complexity for this post), we want to know how much money the Watsons need on Day One of Financial Independence to ensure that they don’t outlive their money. We’re also assuming that they plan to die spending their last penny (the steps for calculating other options are beyond the scope of this post – contact me if you want to discuss this in greater detail).

If we assume a 7% average rate of investment return over their 33 years of financial independence, with inflation averaging 3% and a monthly expense on day one of $7,557 – the Watsons will need $1.7 million in order to enjoy the retirement they’re dreaming of.

Since we know the amount of the nest egg, the next step is determine the financial path that guides them to that destination.

If we assume an 8% average annual rate of return over the next 12 years – while Henry and Penelope are employed – and also assume that they have accumulated $575,000 in their retirement accounts, how much do they need to save each month in order to reach the $1.7 million goal?

The answer is $844.

If Henry and Penelope consistently save $844 each month for the next 12 years, earning an average annual return of 8%, they will reach their retirement goal of $1.7 million and can begin a life of financial independence.

As I mentioned, this illustration is simplified in that it lacks the costs of medical insurance and federal taxes.

I also left out any monthly Social Security benefits they may be eligible to receive in retirement.

Looking for someone who can help you with retirement or financial independence planning?

If you live in the Loveland area – or anywhere along the Colorado Front Range – and want to discuss your financial independence and retirement plan with me, make an appointment for a complimentary one-hour consultation. I am a fee-only financial planner (CFP®)

WINGING IT IS NOT A FINANCIAL PLAN.

Let me help you get on the path to financial security, clarity, and peace of mind.