Thursday, August 24, 2006

Retirement Planning in Your 20s (& Beyond), Part 3: Figuring Out the Nest Egg Needed

So once you estimate what retirement income you'll need, how do you figure out the nest egg that'll produce it? A tricky question for anyone, especially for those of us who are decades and decades away. But I'll give it a try anyway; be warned that this post contains a lot of details, numbers, and statistics!

For starters, who knows how much inflation will occur over the next decades? None of us, obviously. Inflation has varied widely over different periods in history. Some years it's been over 10%; some years it's been negative (deflation). Over the last 80 years as a whole, inflation has averaged about 3.1%, but in recent years it's been higher. Most retirement planning advice I've seen suggests assuming inflation rates anywhere between 2% and 6%, with 3% or 4% (or something in-between) being most common. So given how arbitrary this number is going to be anyway, I'm going to go with 3.5% as my inflation rate.

Great, what does that mean? Well, it means I can figure out what dollar amount I'll need when I start retirement (for me, I'm going to say it's 2050, when I'm 68). I've yet to find a good simple calculator to do this process (tell me if you know one!), but I do know a handy shortcut called the Rule of 72. Basically, if you divide the number 72 by your interest (or inflation) rate, the result is how many years it takes to double at that rate. For example, if you have $100 at 6% interest, in 12 years (72/6) you'll have $200.

So the question is, how many years does it take inflation to double the amount of money you need? I divide 72 by 3.5 to get a little less than 21 years (you can do the same if you want a different inflation assumption). So by 2047 inflation will have caused my income needs to quadruple (double twice), from $16,500 to $66,000. Three more years at 3.5% would bring it up to $73,000. So I need $73,000 in 2050 dollars to retire on. (Another tool you can use is this table-- scroll down.)

And how do you get $73,000 a year (or whatever your amount is)? Well, it depends on whether you want to leave your nest egg intact and live only on the interest (the safest approach, and one that preserves your savings for your heirs), or are planning to use up the savings over time. For me, it's certainly not a priority to leave money behind for my kids-- especially if accumulating the wealth to do so affects my ability to make the family happy when I'm alive-- and as we've established, I'm trying to be realistic but not overcautious here.

So, most advice I've seen suggests that withdrawing somewhere between 4% and 5% of your portfolio in the first year of retirement, and adjusting for inflation thereafter, will likely keep your nest egg alive for 30 years. 3% is the ultra-conservative choice; some people do 6% or 7% or more, but that seems too risky. So I'll pick a 4.5% withdrawal rate. (The table in this article says that's 95% safe over a 30-year retirement.) If I withdraw 4.5% in 2050 to get my $73,000, that would make my number $73,000 / .045, or (drumroll please...) $1,622,222.

Wow. I need almost two million dollars. Granted, that's in 2050 dollars, which is the equivalent of less than $500,000 today, but that's still a sizable hunk of change.

The good news? I'm 24, and I have decades to take advantage of compounding interest, so it's easier than it looks, and if you're near my age you're probably in the same boat. What do I need to do to get my $1,622,222? How can you reach your retirement goal? Check in next time and see!


traineeinvestor said...

One of the issues with making projections on how long your money will last in retirement is volatility in the rate of return.

A plan that assumes that an average rate of return of, say, 8% pa on your investments will mean that your money will last, say, 30 years has a good chance of running out earlier than 30 years. If you get below averagre returns in the early years then even getting above avergae returns later on does not make up for the early shortfall because the later returns will be calculated on a smaller sum of money and you will run our of money sooner than you expected. This is sometimes called "the flaw of averages".

The higher the withdrawl rate on your capital, the greater the damage done by below average returns in the early years of retirement.

My rather simplistic method of dealing with the problem is to postpone retirement by a couple of years beyond the point where I have reached the target nest egg. This will give me a buffer against the possibility of getting below average returns in the early years.

Mr P said...

DinkyTown has great calculators. Probably the most relevant one to this post is this Retirement Calculator.

I am the same age you are and pretty much the same boat. However I think I will have a higher requirement to support my parents in their retirement.

Sally Parrott Ashbrook said...

This is a great series, Penny. Very thought-provoking. My best friend has started reading your blog and called me to talk about this series! :)

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