Bank Deal: Earn 1.00% APY on an FDIC-insured savings account at Barclays.
Over the past few months, I’ve seen several instances in which people are advised to save X times their income for retirement. I first noted this back in July when an Aon Hewitt survey suggested that you should have at least 11x your annual income set aside for retirement.
In his book “Your Money Ratios, ” Charles Farrell argues that you should have 12x your annual salary in the bank before retiring. And the New York Times recently suggested that you should have 20x your annual salary stashed away.
My view — and one that was recently echoed by my pal Mike Piper — is that this is a highly flawed line of thinking. Instead of focusing on income, you really need to be focusing on expenses.
While I realize that many people are living paycheck-to-paycheck, in which case income and expenses are essentially the same, that’s not the case for everyone. And it also ignores the possibility that you’ll scale back your lifestyle in retirement*.
I’ve said it before and I’ll say it again… To estimate how much you’ll need, start by estimating your post-retirement expenses. Average it out across a year. From there, estimate what sort of investment returns you’ll be able to generate — yes, you’ll need a crystal ball for this.
From there, divide that rate (as a decimal) into one to find your multiplier. So, for example, if you think you can generate 4% real returns (i.e., 4% returns after accounts for inflation, so more like 7% nominal returns) then you’ll need 25x your annual expenses (1 / 0.04 = 25). If you think you’ll only be able to generate 3% real returns, then you’ll need 33x your expenses. And so on.
Don’t forget about things like pension payments and Social Security (the latter is hard to predict, I know). These sorts of income streams will offset a portion of your expenses, and should be subtracted out before calculating your multiplier.
So… Assuming you’ve done the math, what’s your reaction? Does that number look scary large? Or are you well on your way?
*Note: Don’t be too cavalier with your assumptions here. Once retired, you’ll have more time on your hands and you’ll also face increasing medical costs as you age. But you’ll hopefully be living mortgage free at that point, and so forth, so it’s not out of the realm of possibility that your expenses will dip.