RETIREMENT FUNDING

WHAT DO YOU NEED TO CONSIDER WHEN FIGURING OUT HOW MUCH MONEY YOU NEED FOR YOUR RETIREMENT?

There is no one size fits all answer for this question. This answer is going to be personal for everyone depending on what they want to do during their retirement, however, there are guidelines you can use to try to approximate the acceptable amount that you should have. What everyone does need to do is to save financially to make sure that they do not outlive their money. 

Retirement typically means a loss of income and employer health coverage and most importantly continued spending. Having no work income coming in anymore and now spending down the amount you have requires proper planning. Some may choose to continue working after retirement on things that may or may not be income generating. 

You want to avoid being forced to have to go back to work because you have run out of funds. 

COMPOUND INTEREST

To start planning for retirement, you need to first understand how compound interest works so that you can utilize that for your plan. Compound interest is money earned on your investment plus money earned on your earnings. For example, let’s say you were to invest $140 and receive 8% compound interest annually. After one month the $140 investment will grow to $140.90, a $0.90 growth. After two months the initial investment of $140 will grow to be $141.81, a $0.91 growth. The reason for the additional growth is that you earned $0.90 on your $140 investment plus $0.01 on your $0.90 growth that you had the first month. I intentionally used 8% compound interest and $140 for this example. The US Stock Market on average sees a growth of 8%-10% so I used 8% as a safe choice. Most financial predictions will use 8% because it subtracts the 2% average inflation expected so that the 8% projection has the same spending power as today. Secondly, to reach an investment balance of a million dollars in 50 years it takes $140 in investments every month with an 8% annual growth, which would mean that your $84,000 contributions into your investment during this time would grow into a million dollars due to compound interest.

MEDIAN AMERICAN INCOME

In 2019, the median personal income in the US was $35,977 per year. If this person were to save 20% every year, they can estimate over 50 years to have a balance of $240,000. If this person were to invest 20% every year with an average 8% annual return, they can estimate over 50 years to have a balance of $1,127,000. They would have almost a million dollars more for investing the money rather than putting it in a savings account.

DO YOU LOOK AT YOUR INCOME OR YOUR SPENDING TO PLAN YOUR RETIREMENT GOAL?

Some financial advisors will tell you to look at your annual income to plan your retirement goal using this number. I prefer looking at your annual spending instead. A good rule to follow is to have 25 times the annual number for when you need to start withdrawing money and this can vary depending on the approach that you take.

PLANNING USING YOUR ANNNUAL INCOME

Let’s say your individual or family income is $100,000 a year. If you are planning on having 25 times this number for retirement, you will need to save $2,500,000.

PLANNING USING YOUR ANNUAL SPENDING

Let’s say your individual or family income is $100,000 a year. Now let’s factor out your mortgage payments and car payments assuming these will be paid off before you retire. You can also factor other expected changes as well such as no longer putting portion of your money in a savings account or a retirement account since you are now using that money, no longer paying expenses for commuting to work, no longer paying expenses for children if you have any and adding or removing any additional expenses that may be a factor for you. Suppose after all this your annual spendings needed is $50,000. If you need 25 times this number for retirement, you will need to save $1,250,000.

Comparing the annual spending with the annual income, reaching a goal of $1,250,000 is much easier and quicker than $2,500,000. This way you are not looking at the figure of $2,500,000 and getting discouraged saying to yourself this may never happen so why even bother and plan on working as long as you can. 

BENCHMARKS FOR RETIREMENT GOALS

For these benchmarks, a retirement period of 25 years is used.

Benchmark 1 – If your mortgage is going to be paid off before you retire, generally you need to have enough saved and invested to match 85% of your pre-retirement spending annually for your retirement years. 

Benchmark 1 Goal = Your Pre-Retirement Spending x 0.85 x 25

Benchmark 2 – If your mortgage is not going to be paid off or you are going to rent during retirement, generally you need to have enough saved and invested to match 100% of your pre-retirement spending annually for your retirement years. 

Benchmark 2 Goal = Your Pre-Retirement Spending x 25

STRATEGIES FOR INVESTING FOR RETIREMENT

Strategy 0 – Put all your money in a savings account.

Assuming you saved up 25 times your annual spending in a savings account and then stop working, it will not last you for 25 years. This is due to inflation. Inflation is the rise in the average price or goods and services which leads to a decrease in purchasing power. Think of it like this: if something costs more than it did before you can now buy less of it with your money. Most savings account grow at a rate much lower than inflation. According to the FDIC, the average savings account grew at 0.33% in 2022. Inflation during 2022 was at 6.5% according to the U.S. Bureau of Labor Statistics. This means that if you kept all your money in a savings account during 2022, your money grew by 0.33% in terms of the money your bank gave you for saving with them, but the prices of goods and services went up 6.5% during the same period. If you retired in 1977 and 2022 was year 25 of your retirement and you had set aside $1,250,000 in your savings account to have $50,000 to spend every year for 25 years, due to inflation the things you could purchase in 1977 for $50,000 would now cost $241,464.52 in 2022. Future inflation can’t be predicted, but one certainty is that what you can buy with $50,000 today will cost more in future years. This is why investing is important and necessary and simply putting money in a savings account will not be enough.

Strategy 1 – Adjust your investments the closer you get to retirement.

Stocks are riskier investments than bonds in terms of the returns you may see on your investment. For this reason, you may consider investing heavily in stocks if you have plenty of years before retirement and shift to investing more in bonds the closer you are to retirement to protect your balance. The reasoning behind this is that if your stocks perform poorly, you still have plenty of time to recover. However, stocks performing poorly may be more drastic if you do not have much time to recover. Outlined below is how you would approach this strategy:

If you are 25+ years away from retirement, invest 80-95% of your portfolio in stocks and the rest on real estate and bonds.

If you are 10 – 25 years away from retirement, invest 55-80% of your portfolio in stocks and the rest on real estate and bonds.

If you are less than 10 years away from retirement, invest 35-50% of your portfolio on stocks and the rest on bonds.

Strategy 2 – Adjust your investments the closer you get to retirement and automate the process.

You can automate the process in Strategy 1 by signing up for a Target Date Fund. The idea behind the Target Date Fund is that your investments align similar to the outline in strategy 1 by considering how far you are from retirement and then adjusting your investments from riskier investments to safer investments as you get closer to retirement. Alternatively, you could also pay a financial advisor to help you manage your money. If you do decide to have an individual help you with your investments, make sure they are a fiduciary. A fiduciary is legally obligated to make decisions based on your best interests and not on their company’s interests or steering you towards options that increases their commission. Financial advisors are not all fiduciaries. 

Strategy 3 – Invest in an Index Fund

With this approach, you would invest your money in an index fund such as the S&P 500 or a similar index. The S&P 500 itself is an index of the 500 largest companies in the U.S. that you can buy the stock for. When you purchase a share of the S&P 500 (You say x number of shares of a particular stock instead of saying I want 10 stocks of S&P 500), you are purchasing a piece of all 500 companies. The idea behind this is that through this index you can invest in all these companies at once instead of just one company with the intention that if one or more companies stock went down or up, it will not impact your entire balance as drastically. The S&P 500 is considered a benchmark of the entire US stock market and historically has seen an average growth of 8% – 10%.

THE 4% RULE. THE STRATEGY FOR USING YOUR MONEY IN RETIREMENT

Now that the income you are receiving has stopped or lowered, a strategy for withdrawing money for use will require accessing your savings, social security if you are eligible, and your investments. Regarding your investments, you would follow the 4% Rule and withdraw 4% of your account every year and this should keep your money available for 25 or more years assuming you have reached your investment balance goal. 

Research supports that the best approach to investing to both maximize profit and to minimize losses is to invest 75% in index funds and 25% in bonds. The data supports that if you are trying to have funds available for 25 years or more for retirement this approach is the most likely to guarantee that you will have the needed funds for that time period. The 75% in index funds will maximize your profits by trying to maintain the 8% average growth rate of the US stock market, the 25% in bonds will hopefully grow to match inflation and will help your portfolio avoid the drastic downward swings of the market in bad years. If the 75% of stocks is matching the typical market growth of 8%, it would mean that your entire portfolio is growing by 6%. If the 25% of bonds is growing at a rate of 2% to match the inflation rate goal of 2% set by the Federal Reserve, which is the national bank of the US, it would mean that your entire portfolio is growing by another 0.5%. Therefore, with your entire investment portfolio growing 6.5% ever year. If you withdraw 4%, you are leaving behind the 2.5% growth to offset the loss your entire portfolio took due to the desired 2% inflation. Some individuals who follow this strategy actually end with having more money when they pass away than the amount they started with when they retired. 

CONSIDERATIONS FOR ENSURING YOU DO NOT OUTLIVE YOUR MONEY

– Withdraw less than 4% of your portfolio annually, possibly between 3-3.5%

– Withdraw 3% when inflation is much higher than 2% or when the US market is not doing well instead of 4%.

– Save 30 times your annual spending instead of 25.

– Do not factor in the incoming funds coming from your social security retirement benefit as a part of the amount of money you need to save to reach 25 times your annual spending. Use social security retirement income as your personal insurance to bridge any gaps in your financial needs due to inflation or unanticipated expenses.

Social Security Retirement Benefits