Many people are looking for answers to one simple question: How much will I need to save to live comfortably in retirement?
The question is simple enough, yet the answer is elusive for many.
It is difficult for many Americans to shift their thinking
from a budget based on steady income to one based on withdrawals from a lump sum retirement account. It is easier to budget according to a monthly income (i.e. I earned $5,000 this month and have $2,000 in expenses, leaving $3,000 for spending and saving) than it is to determine how much is available to spend each month (and for how many years) from a lump sum of $1 million, for example, in a retirement portfolio.
Equity Trust provides a directory of retirement calculators
that run complex calculations and present the information in simplified graphs and charts. Spending time running various scenarios and thinking about the various factors that affect your retirement is certainly a worthwhile exercise.
However, it can be difficult to dive into these scenarios without starting with some basic assumptions. So let’s start with a simple calculation before you embark on the more in-depth calculations the retirement calculators provide.
As Rob Berger outlined in a recent Forbes.com article
, understanding two simple numbers will help you estimate the amount of income your retirement savings can replace.
Income Multiplier = Retirement Savings/Annual Income
Your income multiplier, the first number you’ll need, is the ratio of retirement savings to income. Berger demonstrates that a $1 million portfolio and a $100,000 annual income produces an income multiplier of 10x. Taking his example further, he shows that an annual income of $50,000 from the same portfolio results in an income multiplier of 20x ($1 million/$50,000).
The second number in the calculation is the expected withdrawal rate in retirement. This number will vary for each individual’s specific situation but a commonly used baseline in the industry is 4 percent.
Your Mental Math Calculation
To determine the amount of income your retirement savings can cover, Berger provides the following formula:
Income Coverage = Income Multiplier x Withdrawal Rate
This is a common estimate you’ll find in many articles about retirement planning. How much of your current income will you need in retirement? Will you need 100 percent of your income? Can you manage 80 percent of your current income as the mortgage is paid off and the kids leave the house? This allows the investor to use the familiarity of their current financial situation to estimate their retirement lifestyle.
To continue with the previous example of a $1 million portfolio, $50,000 annual income and 4 percent withdrawal rate, the formula would look like this: 20 x 4 percent = 80 percent income coverage. Therefore, the investor can expect to support 80 percent of the expected $50,000 annual income from a retirement portfolio of $1 million.
An added benefit of calculating your income multiplier is it allows you to estimate how much you will need to save for retirement to hit a particular income goal. Berger provides the following example
to demonstrate this:
“For those making $75,000 a year wanting to replace 80 percent of their income with a 4-percent withdrawal rate, they will need to save $1.5 million for retirement” based on the formulas discussed earlier and outlined below.
Income multiplier = Income coverage (80 percent) / Withdrawal rate (4 percent) = 20x
Retirement Savings = Income multiplier (20) x Annual income ($75,000) = $1.5 million
Clearly retirement planning requires foresight and educated assumptions. A good place to start is by assessing your current situation and using it as a starting place for how you’d like to live in your golden years.
To help, Equity Trust has created several tools for investors looking to determine their financial and retirement goals. Downolad the following FREE tools today: