A person can easily use these two methods to get an idea of how much money they will need saved up by the time they retire and how much they can withdraw annually…
One important input to any retirement calculation is life expectancy. Another is years until retirement.
Two rules-of-thumb have been developed over the years to simplify retirement savings calculations: the 4 percent rule and the Multiply-by-25 rule.
The inputs need to be adjusted to account for inflation.
MULTIPLY BY 25
A website, The Balance, describes how this rule works:
The Multiply by 25 Rule estimates how much money you’ll need in retirement by multiplying your desired annual income by 25.
For example, if you want to withdraw $40,000 per year from your retirement portfolio, you need $1 million dollars in your retirement portfolio. ($40,000 x 25 equals $1 million.) If you want to withdraw $50,000 per year, you need $1.25 million. To withdraw $60,000 per year, you need $1.5 million.
This rule of thumb estimates the amount that you can withdraw from your portfolio. It does not factor in other sources of retirement income, like any pensions, rental properties, Social Security, or other income.
This rule of thumb assumes you’ll be able to generate an annualized real return of 4 percent per year. It assumes that stocks, over the long run (15-20 years or more), will produce annualized returns of roughly 7 percent.
The site reminds us to adjust for inflation depending on how far away you are from retirement:
Here’s an important follow-up detail: You will need to adjust these numbers for inflation, especially if you’re several decades away from retirement. Here’s a quick summary:
* If you’re 10 years from retirement, multiply by 1.48.
* If you’re 15 years from retirement, multiply by 1.8.
* If you’re 20 years from retirement, multiply by 2.19.
* If you’re 25 years from retirement, multiply by 2.67.
To see how this would work, let’s take the example they used of withdrawing $40,000 annually in retirement.
A person who is 40 years old and plans to retire at 65 will be 25 years away from retirement. If they wanted to live a $40,000 annual lifestyle, then they would need to multiply $40,000 x 2.67 to get $106,800.
Then, they would need to multiply $106,800 by 25 to get $2.67 million–that’s the amount they will need saved in 25 years according to this rule of thumb.
Assume the person has zero retirement savings. Using a free online compound interest calculator, and while hoping for a modest 7% annual compound growth rate, the person would need to invest about $40,000 every year for the next 25 years to achieve their targeted $2.67 million balance in order to live a lifestyle that is presently worth $40,000 a year.
THE 4 PERCENT RULE
The Balance also explains the 4 Percent Rule:
The 4 Percent Rule is often confused with the Multiply by 25 Rule, for obvious reasons—the 4 Percent Rule, as its name implies, assumes a 4 percent return.
However, the 4 Percent Rule, more importantly, guides how much money you can withdraw annually once you’re retired, without cutting into your investment principal. As the name implies, this rule of thumb says you should withdraw 4 percent of your retirement portfolio the first year.
Here is a free online calculator: FourPercentRule.com
Applying the 4 Percent Rule to the retirement savings balance of $2.67 million that I calculated above gives an annual withdrawal of $106,800. This is equivalent to a $40,000 lifestyle today, adjusted for inflation.
Quicken explains that the 4 Percent Rule assumes a 30-year retirement and that the retirement account is invested in Large Cap Stocks which are thought to yield a return of about 10% annually.
Quicken also notes something which I have written about: don’t forget old-age medical expenses:
Unexpected expenses often pop up during retirement. Maybe you’ll fall and break your hip. Maybe you’ll need memory care services. Even if you’ve lived a healthy life, and you focus on diet and exercise while you age, you might still face costly medical expenses.
[Chief executive officer and founder of Seniorly, Arthur] Bretschneider says that people are living longer, too. That makes it more challenging to plan for retirement, and is another reason to be more aggressive in your savings, even if formulas such as the Multiply by 25 Rule have you feeling comfortable about your retirement planning.
Using these two simple methods can help a person or family quickly assess the reality of their retirement goals.
What kind of lifestyle do they hope to live compared to how much they earn annually now?
How many years away from retirement are they? More time is better, but inflation will also erode the value of the dollar over those years. Therefore, it must be included in the retirement calculations.