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Retirement calculators provided by financial institutions often make assumptions that lead to intimidatingly large recommendations for retirement savings. In Financial Freedom: A Proven Path to All the Money You Will Ever Need, Grant Sabatier discusses the faulty logic in retirement calculators in greater depth, but these poor recommendations generally stem from three assumptions that sway the calculation:
1. They assume you need your full annual salary in retirement.
This is a common but apparent error when you consider it logically. If you are investing 10% of your income for retirement, then you do not need your full salary to survive in retirement. At most you need 90% since once you are retired, since you no longer need to save that 10% for retirement! If your retirement investments are higher, this becomes more blatantly erroneous. If you make $120,000 and invest 50%, you can survive off of $60,000 a year instead of a much greater $120,000! With taxes, if you are saving 50% gross, you may be able to live off of even less.
2. They assume you will spend down the principal and estimate your lifespan.
Retirement calculators often calculate your supposed retirement needs by taking the amount you will spend for a year and multiplying that figure by the anticipated number of years you will be retired before you die, assuming you will withdraw the money as you go and die with no money. This is problematic because your life expectancy is variable, and withdrawing part of your principal leads to uncertainty.
If you work until a traditional retirement age, you can choose to save enough to cover your expenses for a designated period of time, but you may outlive your money. While an annuity is an option to provide a safety net, planning to save up a principal you do not touch and living off of an assumed 4% in interest provides you more flexibility to live a richer life if the market rises or you receive a life-shortening diagnosis.
3. They assume you will account for inflation.
Since the retirement calculators assume you withdraw the principal, that also means the returns on the principal cannot account for inflation. That means you have to save even more money for retirement to account for the effects of inflation by assuming you will need to withdraw an increasing amount of money each year.
A More Accurate Retirement Calculation
The best part of calculating the money you actually need for retirement is that the calculation is both more accurate and a lower dollar amount than what the retirement calculator tells you! We love a win-win. Additionally, it is a safer calculation where your lifespan does not matter. You can die 10 years early or live until age 120 if you plan correctly. But how can that be?
To save for retirement at any age, determine your living expenses for a year. This will certainly be lower than your salary if you are setting aside money to pay for retirement! It can be even lower if you are setting aside money for your kids’ college expenses or other costs that will disappear before you intend to retire. Remember that dollar amount for living expenses that will support you for one year because we will come back to it!
Assess your risk tolerance for your retirement fund, and plan to save a principal amount that allows you to withdraw somewhere between 3–5%. If you withdraw 3%, you would never, ever run out of money in the history of the market.* We recommend aiming for 4% withdrawal rates but planning to hit your desired principal amount at least five years before you feel you absolutely need to retire in order to mitigate risk. This means you have the flexibility to (a) try out retirement and make sure you did not retire in an unlucky year or (b) continue working to grow a slightly higher principal amount.
Why not just aim for 3%? It takes a lot more money to retire! Here is a chart showing the different principal amounts required for someone who has $50,000 in annual living expenses at different withdrawal rates:
We prefer not to work an extra few years to save up the money for a 3% withdrawal rate unless we hit the market wrong and absolutely have to do so.
Save the principal and live off of the returns of your investment; the market growth accounts for both inflation and your annual living expenses. You can continue to withdraw enough to cover your annual expenses for the remainder of your life while never touching your principal investment. It does not matter how long you live or whether inflation fluctuates significantly because your money is invested in the market, which accounts for inflation over the long run. Some years your annual living expenses (adjusted for inflation) will be more than the growth, and some years it will be less, but that will balance out over time. Because you are living off of only the growth, this gives you an extra safety net and allows you to do this in perpetuity.
So how do you calculate the right number for you? Use the calculation of your annual expenses, and multiply those annual expenses by the following numbers, depending on your preferred rate of withdrawal, to figure what how much of a nest egg you actually need:
Even if you choose the safe route and use a 3% withdrawal rate, this number will likely be lower than other retirement calculators because those calculations assume you need your full salary in retirement. This higher salary then requires withdrawing a portion of the principal slowly over time and estimating your lifespan and how much you will need to account for inflation. That is a lot of guessing!
At Phippen Tax & Financial Services, we do not like to guess. We like to do math and have a backup plan, in case our situation is the outlier. If your retirement plan involves investing until you have a principal that you will never need to withdraw at least five years before the age you will retire, you have a mathematically sound theory and a five-year safety net as a backup plan. Ignore the retirement calculators claiming you need $5 million to retire, and just do the math.
*Past market growth does not predict future market growth, but can serve as a baseline for financial planning with the understanding that nobody can completely predict the future.
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