How much money do you need to retire? A hundred grand? A half million? Ten million?
It is a very important question. Getting the right answer can determine how soon and how well you can retire.
In his book The Number, former Esquire editor-in-chief, Lee Eisenberg talks about why “the number” is so important. He says that for most people, it represents a free pass to a great life without financial stress.
That’s what it always meant to me. When I was in my thirties, I had a number in mind. I figured that if I could achieve a certain net worth, I could quit work and live comfortably for the rest of my life. I hit that number when I was thirty-nine years old. But I quickly discovered that amount was not the number I needed… it wasn’t even close.
Your net worth includes your house, your toys, and all sorts of other assets you may not be willing to give up in retirement. But your retirement “number” is the amount of money you have to save specifically for retirement. It is a fund of assets that will eventually replace your active income and pay for your expenses… after you’ve quit your nine-to-five job.
Because I didn’t calculate my number correctly, I had to go back to work. I picked a new number–a real number–and worked another ten years to hit it. When that day arrived, I felt fantastic. I was able to change my priorities. I devoted the lion’s share of my money to non-financial goals. I never worried about money again.
Reaching your number is a great feeling. If you haven’t yet experienced it, what I’m about to say will put you on the right track…
Most people fail to achieve their retirement dreams, Eisenberg notes. There are two common pitfalls that stop them, he says:
Many people enter their forties and fifties are “ensconced in a cloud of avoidance and denial about the years ahead of them.” They spend their early years not doing any serious retirement planning. They sense they are far behind from where they should be, but they don’t want to face the truth. These are the procrastinators, Eisenberg says.
Other people do retirement planning, but they’re sloppy about it. They don’t know how to calculate their numbers correctly, so they pick arbitrary numbers and hope for the best. This is the mistake I made when I first retired. Eisenberg calls these people “pluckers,” because they pluck numbers out of thin air.
You don’t have to be either one of these people. You can begin to realize your retirement dreams today by discovering your retirement number.
Let’s do that now. Let’s figure out how much money you have to save in order to quit work and enjoy retirement.
To calculate your magic number, you need to know five other numbers:
1. How much money you have saved.
2. How many years you have to save money before you retire.
3. How much money you will need in order to enjoy the retirement you want.
4. What rate of return you expect to get on your savings.
5. The average rate of inflation.
Take These Five Steps and You’ll Have Your Magic Number!
I am going to give you five calculations. Each one should take just a few minutes. The entire process, including all five steps, should take no more than half an hour. Please do it now. In terms of your future wealth and happiness, it may be the most fruitful thirty minutes you ever spend.
But before we begin, I want you to write down two numbers: 8 and 12.5.
Step 1: Write down how much money you have already saved towards retirement. This should include not only liquid assets (such as cash, stocks, and bonds) but also any illiquid assets (such as an auto collection or a second home) that you plan to sell prior to retiring.
Sell the house you own (if you own one) for a less expensive house more suitable for retirement and add any profits from the sale into your retirement savings.
For example, if your house is worth $350,000 and you will be happy in a smaller house that will be $100,000 cheaper, you can add $100,000 to your retirement savings.
Step 2: Write down how many years you have before you hit your retirement age. If you are thirty-five years old now and plan to retire at sixty-five years old, that number is thirty. If you are fifty-five years old now and want to retire at sixty-five years old, that number is ten. But be realistic. If your retirement fund is small right now, you might have to work another five years to reach your goal.
I told you above that I hit my number before my fiftieth birthday. That allowed me to start writing fiction and poetry several hours a day… and take lots of vacations. Since I still liked my line of work, I continued to spend some time every day as a consultant to publishers. And that turned out to be lucrative.
Keep that in mind when you hit your number. Like me, you may decide to keep working on a part-time basis. If you do, you’ll be making more than you need. Enjoy it. Don’t increase your spending.
Step 3: The next step is the one most people start with: deciding how much money you will be spending each year in your retirement to enjoy the lifestyle you want.
A good way to do this is to start with how much money you are spending now on your current lifestyle. I told you how to make that calculation in an essay I wrote a few months ago, titled Three Numbers that Are Essential to Your Wealth. I called that your lifestyle burn rate. What you are doing now is figuring out your retirement lifestyle burn rate (RLBR).
Take your current lifestyle burn rate and add to it any “extras” you want to enjoy. Let’s say, for example, that your current lifestyle burn rate is $80,000 a year. To make your retirement more fun, you want to own an extra car–a sports car–and join a golf club. This will cost you an extra $10,000 a year. Add $10,000 to the $80,000 and you have $90,000.
Now subtract from $90,000 any expenses that you currently have but will no longer have when you are retired. This commonly includes expenses for your children and other expenses related to having a family with children. If those expenses are currently $15,000, then you will deduct that $15,000 from the $90,000 and you will be left with your true RLBR of $75,000 a year.
One caveat: In determining your retirement lifestyle burn rate, you have to be realistic. If you are already fifty years old, have only $300,000 in your retirement savings account, and are currently spending $80,000 a year to live… it’s unlikely you will get your RLBR up to, say, $500,000.
Step 4: Subtract from that number (RLBR) any income you are confident you’ll be getting during your retirement.
For example, if you trust that Social Security will still be around when you retire, you can find out what your projected yearly Social Security income will be and subtract that from your RLBR. You can do the same with any pension income you expect. And finally, if you intend to work part-time during retirement, you can deduct that, too.
Working with the same $75,000 RLBR number, you deduct $15,000 a year you expect to get from Social Security, another $5,000 a year you expect to get from some pension, and another $5,000 a year you expect to get by working as a golf ranger two days a week. This reduces your RLBR from $75,000 to $50,000.
This is your net retirement lifestyle burn rate. Save this number.
Step 5: Now it’s time to figure out your magic number, the amount of money you need to save in order to retire.
Using the same example, what we are looking for is an amount of money to invest that will generate $50,000 a year in after-tax income.
So how much money is that?
Again, that depends. It depends on the return on investment you can expect to get on your retirement savings.
If you expect to get only 5% on your money, then your number–the amount you’d need to save before retiring–would be $1 million. (One million dollars generates $50,000 a year at 5%.) If you could get 10% on your retirement funds, you could retire much sooner… since you’d need only $500,000 at 10% to generate $50,000 in annual income.
So what rate of return should you plug into this equation?
That depends on what kind of investments you use. If you put all your money in municipal bonds, you could be making 3%. (Municipal bonds are yielding only 3.13% today.) You could earn about 8% by putting your money in stock index funds (since 1970, they have returned 8.14% after taxes of 20%), but I don’t like the idea of having my retirement fund in an index fund because the stock market can fluctuate greatly from year to year.
A better choice would be the kind of stocks we recommend each month in The Palm Beach Letter. They are selected to give you–at minimum–an 8% after-tax return. But I wouldn’t want all my retirement funds in stocks, because even the best of them are still subject to annual fluctuations.
To compensate for the temporary low yield of municipal bonds and the volatility of the stock market, I’ve designed a simple three-asset portfolio that should give us 8% reliably and steadily. Or as close to that as one could possibly hope for.
A Sample Retirement Portfolio Strategy
I’m thinking of a portfolio consisting of high-quality dividend stocks, high-yielding bonds, and rental real estate.
Specifically, I would recommend an allocation of 50% rental real estate, 30% dividend stocks, and 20% high-yielding bonds.
In future essays, I’ll talk in more detail about how I came up with these calculations, but I feel confident that you can expect the following after-tax minimums from each of these portfolios: 3% from bonds, 6% from dividend stocks, and 12% from rental real estate.
A portfolio that gave you 3% on 20% (your high-yielding bonds), 6% on 30% (your dividend stocks), and 12% on 50% (your rental real estate) is a portfolio that will give you just over 8% overall.
The Final Step: Now we are ready for the number. To figure out your number, take the net RLBR and multiply it by the reciprocal of the expected rate of return. These are the numbers I asked you to remember in the beginning of this essay: 8 and 12.5.
Using the same example, you would multiply the $50,000 (net RLBR) times the reciprocal of 8%, which is 12.5. Fifty thousand dollars times 12.5 is $625,000. That is your magic number!
So if your net RLBR is $100,000, then your magic number is $1,250,000. If your net RLBR is $300,000, then your magic number is $3,750,000.
Get it? Just multiply the income you will need by 12.5.
In case you are lost, let me break it down for you again using the original example. The following is just an approximation…
You need $50,000 a year from your retirement savings. Knowing you can expect to get an average yield of 8% a year, you do the math and determine that you need a total of $625,000 in your retirement savings portfolio. Twenty percent of that amount ($125,000) would be in bonds yielding 3% after taxes. That would give you $3,750 a year. Thirty percent ($187,500) would be in dividend stocks yielding 6% after taxes. That would give you $11,250. And 50% ($312,500) would be in rental real estate yielding 12% after taxes. That would give you $37,500 per year. The total of $3,750, $11,250, and $37,500 is $52,500.
Now remember, that is the minimum. If you got higher yields–even moderately higher yields–you’d do better. You will have more income than you need that year. You will have a choice: either save it for a rainy day or spend it. You won’t need to save it, as your retirement fund will continue to produce 8% yields.
I’d like to end here, but there is one final number we haven’t looked at yet… And that is the rate of inflation.
When planning for your retirement, you have to consider the effects of inflation on the value of your portfolio. That’s because in most cases, inflation makes future dollars less valuable than they are today. The $80,000 a year we’ve been using in this essay, for example, will still be $80,000 in ten, twenty, or thirty years… but it will buy far fewer things than it can buy today.
So how do you account for that in your planning?
One way is by owning businesses that keep pace with inflation because they are able to raise their prices to match inflation. Many of the stocks we recommend in our portfolio are of that kind. Having 20% of your portfolio in such stocks will definitely help.
Bond yields should increase in the years to come as well. Today, they are low… and our plan is based on a 3% yield. But these are likely to increase in the years ahead. So that will be some help, too.
But the main inflation hedge you have in the portfolio I recommended is the rental real estate portfolio. Real estate, as a tangible asset, appreciates during inflationary times. According to The Case Shiller Index, which has tracked real estate sales of existing homes since 1987, the average annual increase for real estate is 3.6% over this 25-year period. Compare that to the reported Consumer Price Index during the same period at 2.9%.
I didn’t count this appreciation into the mix when we went through the numbers. That means that half of your portfolio will likely increase by 0.7% above inflation, not counting the positive effects you might get from your stocks and bonds.
More importantly, as a landlord, you should be able to increase your rent to match with inflation. I’ve been doing that with my rental real estate portfolio for more than twenty years.
These factors should go a long way towards protecting the validity of your “number.” But if you want to be extra sure, you can simply use a multiplier of more than 12.5–just to be sure. In the case of our existing example, you would multiply $50,000 by, say, 14, which would increase your number to $700,000 rather than $625,000.
Again, I feel safe using 12.5 as a multiplier (for the reasons I mentioned)… but if you have twenty, thirty, or forty years to go before retirement, then you might want to use 14.
I know this has not been the most exciting essay you’ve ever read from me. But in terms of your retirement planning, it may be the most important.
Please take the time to do your calculations today. The moment you have your number, you’ll be motivated to begin the journey of achieving it. The sooner you begin, the sooner you can retire.[Ed Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]