"How Much Do I Need?"

About a year ago, the whole family was in the car, rushing out of the house one morning.  Our first stop was Sprout's preschool.  As we were running late, Rooty had asked Fern to help Sprout put on his socks.  Fern tried, but then complained.
 

Fern: He won't let me.

Rooty: What do you mean?

Fern: Instead of giving me his feet, he's hiding them from me.

Rooty: Sprout, you can help, too, you know.

Sprout: No, I can't.

Rooty: What do you mean?

Sprout: Fern already has his shoes and socks on.

Misconception is fairly common for us humans.  Sometimes to cute effect.  Sometimes, not so much.  Take retirement savings.  Studies have shown that a surprisingly small percentage of people have a realistic idea of how much they will need in retirement.  Not so cute.
 

So how much do you need?  Turns out, not as much as you think.  Or, a whole lot more than you think.  How should I know?  I'm not a mind reader.

So let's have some fun.  Just off the top of your head, take a wild guess.  Go ahead, come up with a number.  I'll wait.

You're thinking too hard about this.  Just come up with a number.

Seriously, I don't have all day.  Well, I'm retired, so I guess that's wrong, I do have all day.

Okay, I've got a blog to run here.  Let's just say you thought $500K.  Bad news.  That's probably quite a bit less than you need.

Now let's say you thought $5 million.  Good news.  That's probably quite a bit more than you need.

"How would you know what I need, Doorway?  You don't know my situation."

Well, that's true, Slash.  That's why I said probably.  I'm just guessing based on my readership and based on my experience of modeling with a wide variety of online tools, proprietary tools from financial firms, and my own spreadsheets.

"Okay, then.  Tell me more about these tools."

Someday, Slash, not now.  I've tried several times now to blog about tools, but to be honest, I just get bored.

"Imagine that.  Boredom associated with your blog.  Who'd have thought."

One thing I will share is a rule of thumb that seems to be fairly decent despite all the caveats and inherent issues of oversimplification.  A rule that gives a result surprisingly close to all these more complicated, and often expensive, models.

Presenting...The 4% Rule.  Want to have enough money to last throughout your retirement?  Ensure your annual expenses are no more than 4% of your nest egg in year one, and grow no faster than inflation.  To calculate, take your annual expenses (which you know, because you are now tracking them, right?) and divide by 4%.  Or, multiply by 25.  Same thing.

Disclaimer: The 4% Rule is a rule of thumb that has generally worked historically.  It is an empirically derived probability, not a guarantee.  (There is no guarantee that your money will last no matter how much you have.)

Say your annual expense is $80K.  Your retirement savings then should be:

$80K / 4% = $2.0M.

"Wow, that's less than I thought.  Or, more than I thought.  How should I know?  I don't think about it."

Unfortunately, many people don't.  And they end up surprised to find that they wasted precious years working when they really didn't have to do so.  Or, more often, that they should have saved a whole lot more when they had the chance.

"That's easy, then.  No need for tools.  No need to think."

Well, as I said, there are some caveats.  Here are a few of the biggies:

"Expenses" include taxes.  I know, totally unfair, right?  But this is important to understand because most of the articles and web sites that talk about the 4% Rule don't even mention taxes.

Which reminds me, I had better stress this now because I may never get around to blogging about tools:

Always know how taxes are handled in any retirement tool you use.

Some tools don't include taxes at all, some include federal only, some include federal and state.  (None of the tools I have come across include property tax.)  Dig into it, or you may make the wrong assumption.

So anyway, let's assume your tracked expenses are $80K a year.  You estimate that in retirement, you'll pay total state and federal taxes of $10K on top of that due to dividends and realized capital gains.  Then your total expenses are $90K, not $80K.  So your retirement savings needs to be $90K / 4% = $2.25M.

You can only live 30 years in retirement.  Well, okay, that's an exaggeration.  The point is, if you want to retire early, you probably will want to play it safer to improve the odds that your savings will last because the 4% Rule is based on a 30 year span.  So take that $90K and divide by 3.75% instead of 4%.  Your retirement savings now needs to be $2.4M.

Home equity is excluded.  Yes, your home is kind of an investment.  Sort of.  (Not really.)  Let's face it, your home is your residence.  Unless you plan to sell it, move somewhere much cheaper, and pocket the difference upon retirement, leave the equity out.

College savings is also excluded.  And this should be a sizable chunk of change if your kids aren't in college yet.  Like, $250K per kid or so.  Unless you plan to sacrifice your children's education for your early retirement (not a good idea...what would the neighbors think?), you need to leave college savings out of the total, too.
 

"So given all that, my net worth needs to be more like...three million or more?"

Under these circumstances, yes.  But hey, $3M is not really all that bad.  It may seem like a lot at first, but if you follow the 3 Simple Rules (earn a good income, save like crazy, invest wisely) it will add up very quickly.  Compound interest - the eighth wonder of the world.

Besides, who says you have to spend $90K a year?  You are in control, you are enlightened.  Lower your spending by just $10K a year and you cut your retirement need by a cool quarter of a million.

Remember, the 4% Rule is is just a quick rule of thumb to get you in the right ballpark.  Before you retire, spend some time with the more sophisticated (albeit, boring) tools that are out there.  They won't necessarily give you a better answer, but by using them, you will gain valuable insight into key sensitivities and the risks in your plan.

Oh yeah, one more thing.  You're going to hate this post script if you live outside the United States.  I once read, years ago, about a study on something like fourteen different developed countries.  The 4% Rule failed in all but the U.S.  So, if you are Canadian, Japanese, Norwegian or Albino, find out what would have worked historically in your country.  Maybe 3.5%.  Sorry.