We calculate how much money the average household needs for retirement at different points in their life.
We use two different scenarios: drawing down the portfolio completely and preserving the principal.
The numbers shown are based on an average household but could be roughly scaled to other age and income levels.
We recently wrote an article to help investors gauge how much money they may need when they retire. The article was mostly about examining the conventional wisdom around the “correct” amount of retirement savings and had little in the way of actual concrete numbers. No doubt, this may be frustrating to some readers. In fact, it reminds me of a high school teacher I had who when pressed by students on how long term papers had to be would always respond “long enough to cover the subject but short enough to keep it interesting”. Students would always invariably pester him with follow up questions: “Is eight pages ok?” then “What about six?” or “What if mine only turns out to be five pages?” The people demand actual numbers! So to satisfy those readers who want some actual numbers, I’m going to try to do just that.
We’ll use an example that closely matches the average household. So, from our previous article you’ll remember that the average household spends somewhere around $45,000 at the full retirement age of 67. The median household income is currently around $60,000, so we’ll use that as a basis for estimating Social Security benefits. We’ll assume the household has a main breadwinner that earned around $50,000, with another member who worked sporadically for a good chunk of their career due to staying home with the kids and earned the remaining $10,000 for the household. The high-earning member would file for full benefits at age 67, with the spouse filing for half the high earners benefits. That gives our hypothetical household $26,550 in Social Security income, which means they now only need $18,450 in investment income to meet their budget.
We’ll look at two different scenarios. In the first we’ll look at a scenario where the portfolio is completely drawn down, and in the second we’ll look at how much an investor would need to keep the principal intact.
To calculate the time value of money as well as increases in Social Security benefits we will use a 2.85% inflation rate. This is above the current inflation rate, but it is in line with the historical average going back several decades. When calculating how much money an investor would need we are going to assume 7% annual returns and that the investor is contributing $3,000 per year to their retirement accounts. The $3,000 figure is what the average American contributes to their 401(k) plus our best guess at what a company match might be.
The data for our first scenario is below. Everything in the table below is in “today’s dollars” unless otherwise specified.
We calculated an investor would need about $220,000 total to fund their retirement. As you’ll recall from our previous article, research found that retirement spending tends to fall over time, dropping by an average of 14% every five years. Therefore, we broke the retirement period into four distinct five year phases ending at age 87, with each spending falling 14% each phase (the new total is then adjusted for inflation). We then added up the total investment income needed each year to get the $220,000 figure.
So if you’re 40 years old, we can look at the table and see you need to save up $468,964 for retirement, which when you’d reach 67 would be the equivalent of that $220,000 figure today. Assuming you earn a 7% return and you (plus any company match) are contributing $3,000 per year, you should have a portfolio of about $40,000 today if you want to be on track for retirement. The table works the same way for any of the other ages listed (30, 50, etc).
In our second scenario, we modeled what an investor would need for retirement if they didn’t want to touch the principal. For this scenario we assumed a 4% withdraw rate for the portfolio which is the midpoint of what’s considered a safe withdraw rate (3% to 5% depending on the source). Because the investor doesn’t want to see their portfolio value decline we did not model any drop in spending as the issue is moot. We kept everything else the same (2.85% inflation rate, 7% investment returns, etc).
For this scenario an investor at age 40 would be shooting for a portfolio of almost $1M in today’s dollars, which would be the equivalent of the needed $461,250 today by the time they reached age 67. To remain on track for that goal the investor would want to have a portfolio of at least $122,562 right now. For other ages, just read the table the same way.
Obviously the previous numbers are just rough guidelines and we took a few shortcuts to make some of the calculations easier.
For example, spending in retirement tends to slowly decline each year with the decline totaling 14% on average over a five year period. We simply chose to divide it into five year chunks to make the math a bit easier.
We also assumed that the portfolio wouldn’t really be growing in retirement. This definitely makes sense for the first scenario where the entire portfolio will be drawn down. The household wouldn’t have any financial cushion to make up big losses so a portfolio that was invested very conservatively, likely mostly or completely in safe, investment grade bonds, would make sense. In that case the portfolio would basically keep up with inflation. In the second scenario things might be a bit unrealistic for more aggressive investors. Since the household has a larger financial cushion, investing some portion of the portfolio in stocks could be appropriate and returns may outstrip inflation.
We also didn’t make an allowance for increasing contribution over time, again to make the math easier. Of course, given that household income has been stagnant for several decades, perhaps this assumption is actually prudent.
In any case, we hope this gives readers a rough idea of what they might need for retirement and a way to gauge whether they are on track or not.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.