How much do I need to save for retirement?

aka... What's my number?

A correspondent asks:

I’d like to retire at some point and am wondering what is my retirement savings target?

Finishing Up in Philly

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Hi Finishing Up-

Everyone of a certain age asks some variation of this. Here’s how I answer the question of how much you need to amass in retirement savings to maintain your existing standard of living:

1. Determine your annual Social Security benefit — net of taxes and Medicare premiums. I recommend you wait until age 70 to claim but for this purpose, use the amount that corresponds to your retirement age.

2. Determine the after-tax value of any pension or other guaranteed lifetime payment.

3. Determine your annual spending.

4. Subtract #3 from the sum of #s 1 and 2. This is your income shortfall.

A simple answer to this question is you multiply your income shortfall by the number of years you need your after-tax savings¹ to last.

I’ll explain with a few examples.

Examples

1. You retire with an after-tax and after-Medicare Social Security benefit of $40,000 per year. Your spending is $75,000 and thus your income shortfall is $35,000. If you plan to live another 20 years (and then immediately drop dead), you’ll need after-tax savings of $700,000 ($35,000 x 20 years).

2. You retire with a net Social Security benefit of $15,000 and an after-tax pension of $45,000. Your spending is $80,000 per year, giving you an income shortfall of $20,000. All of your savings are a pre-tax IRA with a current balance of $500,000. Assuming state and federal income taxes of 15% on the IRA distributions, the after-tax value is $425,000. Your savings should last ~21 years (425/20).

3. You retire with no Social Security or pension income. If you’re spending $60,000 per year, you’d need $1.2 million (20x) to fund a 20-year retirement; $1.5 million (25x), would fund a 30+ year retirement.

Some Notes and Complications

To keep things simple, I’ve glossed over a few things:

1. Inflation

   I assume your spending and your Social Security benefit both grow by a rate of inflation.² Because your spending is bigger than your Social Security, this has the effect of under-estimating how much is needed to save.

2. Future one-time expenses

   There will be years that you’ll spend extra on some surprise expenses and you’re unlikely to offset these expenses with lower spending in other years. This also has the effect of under-estimating your saving target.

3. Your unknown expiration date

   The uncertainty of not knowing our expiration date is the hardest to plan for. However, we should be conservative so that we don’t outlive our savings and have a bit left over to pay for the funeral. This also tilts my analysis to under-estimate the amount needed to save.

4. Investment returns

   Yes, your savings are generating investment returns and I’m assuming by a rate greater than inflation. This positive effect will cause you to deplete your savings more slowly than I suggested. Because of the power of compound interest, the bigger the multiple of savings you’ve accumulated, the bigger the positive effect. Let me explain by example:

   1. If you’ve saved “just” 10x of your income shortfall, your savings should last 11 years (not 10).

   2. If you’ve saved 20X your shortfall, your savings should last 24 years (not 20).

   3. If you’ve saved 25x your shortfall, your savings should last 30+ years and likely outlive you. You can reasonably think of 25x your income shortfall as an upper bound of how much you need to save for retirement (unless you retire quite young).

The first three points cause my rule-of-thumb to understate how much you need to save; the fourth point does the opposite — it overstates how much you need to save, especially for a longer retirement.

Summary

These four complications roughly balance out and my Occam’s Razor keep-it-simple approach is a reasonable rule-of-thumb:

To retire and maintain your current standard of living, multiply your income shortfall by the number of years you need your after-tax savings to last.

1. For your savings that are in a pre-tax retirement account, reduce its value by the future tax liability.

2. I use an inflation rate of 3% and an after-tax rate of return of 5%.