The future is uncertain, and that can be a little scary – especially when planning for retirement.
You’ve been told to save and save more, but how much is enough? Can you save too much? How do you know if you’ll run out of money in retirement? If your spine is tingling right now, you’re not alone: Nearly half of all Americans planning for retirement are worried about outliving their savings, according to a study by the American Institute of CPAs.
The good news is that there are ways to gaze into your financial future and gauge whether you’re building an adequately sized nest egg that fits your lifestyle in retirement.
QUICKLY ESTIMATE YOUR RETIREMENT NEEDS
If you want to ballpark the amount you’ll need to save, or can spend, for retirement, you can use a couple shortcuts:
- The 4 Percent Rule: This guideline suggests you can safely withdraw 4 percent of your portfolio in the first year of retirement and continue to do so – while adjusting for inflation – throughout your retirement. If you have $1 million saved for retirement, you’d withdraw $40,000 in year one. If inflation is 2 percent, in year two you would withdraw $40,800 ($40,000 x 1.02). In year three, if inflation stays the same, you’d withdraw $41,616 ($40,800 x 1.02). This can help you see how far your retirement savings can take you.
- Rule of 25: How much money do you want to generate with your savings each year in retirement? What would you be comfortable with? Got a number? Now, multiply it by 25. This gives you a (very) rough estimate of how much you’ll need to save in retirement to generate that income for 25 years in retirement. If you want $40,000, that amounts to $1,000,000.
As you can see, when you use the 4 Percent Rule, you’re implicitly applying the Rule of 25, but in reverse. You’re simply solving the problem from two different vantage points.
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GOING DEEPER WITH SIMULATIONS
In lieu of crystal balls, financial planners let math do their forecasting, and a probability analysis (technically it’s called a Monte Carlo simulation) is a popular approach. Monte Carlo simulations were first used in the Manhattan Project to develop the atomic bomb, but today they’re put to work in rescue operations, weather forecasting, engineering, communications – anywhere people want to reduce uncertainty about future events. That makes them excellent tools for modeling the risk of running out of money in retirement.
Here’s how this kind of simulation works: Take a host of variables, assign each one a value and punch them into an algorithm. The formula runs calculations to determine how those variables will respond in thousands of different scenarios, along with the probability a given scenario occurs.
Here are common variables that would be used in a retirement simulation:
- Portfolio size: How much money you have saved
- Asset allocation: The proportion stocks, bonds and other kinds of investments in your portfolio
- Withdrawal rate: The amount you plan to take out each year in retirement
- Inflation: That pesky force that slowly raises the prices of everything over time
- Time horizon: How many years you will need your money
- Contributions: How much you will contribute each year until retirement
Without entering a single number, you can already glean some excellent insights about retirement planning. These six variables are the primary drivers of growth and sustainability of your retirement savings.
When you punch in numbers for each variable, the algorithm tests your retirement needs against hundreds of potential scenarios, ranging from Great Depression-style bad to Booming 50s good. It can then give you a probability for how likely you are to meet your income needs across the spectrum of scenarios.
From here, you can shape and reshape your destiny. What if you withdraw more? What if you work another year? What if you changed your asset allocation? You can work with a financial professional to run simulations over and over, until you find a risk-to-uncertainty ratio you’re comfortable with. From there, you can layer those expectations into all the facets of a financial plan.
SHAPE YOUR DESTINY
Ultimately, whether you use the Rule of 25, the 4 Percent Rule, or a Monte Carlo simulation, you’re getting a generic, back-of-napkin estimate for your retirement savings. But there’s a lot of “you” missing in these estimates – your health or your personal ambitions, for example. While these are great starting points, a financial professional can go the next mile and help you build a plan that checks out mathematically and personally.