How much money you need "in the bank" when you retire depends on many factors, including the following:
Living standards. How much money will you need each month to live the way you want to live? Does that include travel? A second home? Gifts or support to children and grandchildren? Create a budget as a starting point, and then assume that it will increase at least 3 percent per year to account for likely inflation.
Income. Other than your savings and investment income, how much income will you have? Do you have Social Security or a pension? Will you continue working -- perhaps part-time or at a job where you give back to the community and don't need to earn as much as when you were supporting a family and saving for retirement. If so, for how long and how much do you expect to earn? You can subtract this from budget to determine how much you need to earn in investment income each month.
Longevity. Based on your health and the lifespan of your parents, how long will your savings have to last? Until you're 80, 90 or 100. But beware, I just read an article about a healthy 103-year-old whose parents died at ages 53 and 72. Annuities can be good tools to protect against outlasting your money. They involve paying an insurance company for a guaranteed stream of income for the rest of your life, starting now or perhaps at sometime in the future. If you elect to use an annuity, you would deduct the cost from your retirement savings, but add the monthly payments to your income.
Goals. Do you want your funds to last just as long as you do, or is it important for you to leave something for your children and grandchildren? If so, life insurance may be a good solution. Just be sure to add the premium payments to your budget.
Unexpected events. It makes sense to leave a cushion for unexpected events, such as a child who needs help or the need for long-term care. The latter can insured against with long-term care insurance, the premiums for which would also have to be added to the budget.
Investment returns. Any calculation will have to include an estimate of returns on an investment portfolio. In the example below, I use a 6 percent return, but depending on your optimism about the market you can factor in a higher or lower figure.
When you will retire. The sooner you retire, the more years you'll have to cover from savings and investments and the more likely that an unexpected event will occur.
With all of these questions answered, you can determine how much you need invested to retire. Here's an example:
A healthy couple determines that they need $120,000 a year to live the way they would like, factoring all of their expenses as well as likely taxes. They have no pension, but they have a combined Social Security income of $36,000 a year. This means that they will need to generate $84,000 a year from their savings and investments, or $7,000 a month.
In that case, assuming they want to cover their needs up to age 100, they should have the following amounts saved up at these retirement ages:
Age 65 $1.9 million
Age 70 $1.7 million
Age 75 $1.5 million
Age 80 $1.4 million
Here's how I arrived at these figures. If we assume that the investments will earn 6 percent per year on average and we want to increase such returns by 3 percent per year, then we need to reinvest 3 percent each year. If they retire at age 65, they can withdraw 4% a year and their money, under these assumptions, will last for 40 years. If they retire at later ages, they can withdraw a higher percentage each year, meaning that they don't need quite as much invested.
Of course, planning ahead, our fictional couple who could retire today with an annual income of $120,000 may well need substantially more a decade or two from now, given the likely erosion of the buying power of their income. Taking that into account, we can refine these figures a bit further. Let's assume that the couple is 55 years old today, that they need $120,000 to live on today, and that the Social Security cost of living increases will keep up with inflation. Then, the following chart shows both their income needs and their capital needs at each retirement age:
Age 65 $162,000 $2.45 million
Age 70 $188,000 $2.5 million
Age 75 $218,000 $2.55 million
Age 80 $250,000 $2.7 million
As you can see, these results are contrary to what one would expect. The first chart shows that an 80-year old today needs a third less in savings and investments than a 60-year old today, because he doesn't need to generate income for as long nor account for inflation and its compounding effects for as long. However, this doesn't help the 55-year old planning for retirement very much, because she has to factor in inflation between now and retirement in determining her income needs. Perversely, this means that at each retirement age, she'll actually need a bit more set aside than at younger ages, $100,000 more if she waits 10 years and $300,000 more if she waits 20 years.
However, this is substantially less than her savings would grow if simply left invested over this time period. Assuming a 6% after tax return, if our retiree has $1.4 million in savings and investments at age 60 --$1 million short of what she needs to retire on at that age -- and doesn't add to it or withdraw from her nest egg for 10 years, at age 70 she'll have the $2.5 million she will need at that point.
In short, calculating the magic number of how much you will need to retire and the magic age at which you can retire is a complicated calculus. Factors that aren't included in this analysis include the fact that delaying retirement will mean a higher Social Security payment. In addition, if future retirees are not concerned about leaving funds for children and grandchildren, they can be a bit more agressive about drawing down their savings, perhaps planning to run out at age 100. Financial planners can help make the calculations and provide information about products such as long-term care insurance, annuities and life insurance that can help you reach your goals.