I have always been a relatively prudent person, much more of a saver than a spender. However, it was not until the last year that I started thinking seriously about investing for my retirement.
In planning for my own retirement I undertook significant research and I would like to share what I learnt as it may assist others who are starting their retirement planning journey. I also wanted to explore several common retirement rules of thumb including the 25x rule, the 4% rule and the 100 minus your age rule. What I will share in this article will not apply for everyone, however it will probably be applicable and useful to many people when planning for their own retirement.
Before we go any further I want to state that I am not a financial adviser and that you should always seek independent financial advice before making any decisions about investing for your retirement or otherwise. Similarly, historical inflation and stock market gains are not guarantees of future performance, so please keep this in mind as your read through this article and digest the advice that I am about to share.
Have A Retirement Conversation
We all know that talking about money can be a challenging topic, However, if you do not have an open conversation with your partner (or yourself for that matter) you will not have a solid foundation on which to plan from. The objective of this conversation is to understand when, where and with what lifestyle you would like to retire. Some good questions to discuss are:
- When/What age would you like to retire?
- Thoughts on part time work during retirement?
- How much income do you want in retirement?
- Where/Which country do you want to retire to?
- Do you want to own your home or rent in retirement?
- Attitudes to saving and investing? Risk tolerance level?
- Thoughts on leaving an inheritance?
- How long do you expect to live?
- How do you plan to pay for future medical expenses?
Calculate Your Retirement Budget
If you have a monthly/annual budget that you track on a regular basis then you already have a head start on this activity. But either way, having an understanding of your expected budget to achieve the standard of living that you would like in retirement is key.
All costs should be what it costs you today. Personally, I found that working out costs at a monthly level and then multiplying by 12 to get the yearly total worked best for me as it was easier to estimate monthly rather than annually.
My approach was to split this budgeting process into Essential Costs and Discretionary Costs:
- Essential Costs: Are those costs that you require to survive in retirement. These include rent, utilities, groceries and transport. Depending in which country you live medical insurance or medical expenses might also be included here.
- Discretionary Costs: Are those costs that you require to enjoy your retirement. These could include going on vacation, eating out in restaurants, entertainment and shopping for non-Essential items.
If you are renting and you do not own your own home, then rent will probably be the largest element in your Essential Costs. However, this does not always mean that buying your own home is the best option. This will very much depend on where you want to live. Mortgage repayments, property purchase tax, annual maintenance costs and annual property taxes will all need to be factored in.
If you decide that buying a house is the correct decision for you then I would highly recommend paying off your mortgage before retiring.
One benefit of renting is that it gives you the flexibility to move to a cheaper home or for that matter to move to a different area or even a different country. Of course, you could always sell your home and move, but there is typically more friction and costs incurred in doing so when compared to moving between rented properties.
Here is a budget example for a couple planning their retirement that I put together as an illustration. The actual figures in this example are not important. However, the process of understanding your required Essential Costs and Discretionary Costs in retirement is important.
As you can see from the examples above, this couple have calculated that their annual budget in retirement based on costs today is $100k. This is just an example and your budget may be higher or lower depending on the lifestyle that you would like in retirement.
If you will receive a national/government/state pension on retirement, then you could potentially subtract this amount from your annual retirement budget. Or, you can be more conservative in your retirement planning and ignore this future income from your calculation.
Accounting for Inflation
Inflation means that goods and services will cost more over time. Or to put it another way the effective purchasing power of each dollar becomes less each year. Just because your mobile phone costs $100 dollars per month today does not mean it will always cost $100 per month for the rest of your life.
Historically inflation has been running at around 2.5% per year in the US and other developed countries. Now this may not sound like much, but when you apply compounding over multiple decades this can really have a huge impact, both before and after retirement.
Lets take that $100k per year income that our couple would like in retirement. Assuming that they retire today at 65 and live until 100 (35 years), by the end of their life they would need to have a spending power of over $230k in order to maintain the same level quality of life as they have today due to inflation.
However, if you are decades away from retiring, then the impact of inflation can be even more dramatic as the inflation has longer to compound as we can see in the table below which assumes that you retire at 65 and live until 100.
If you are 35 today and plan to retire at 65 (30 years until retirement in the table above) then that $100k budget based on today's cost of living will have grown to almost $210k by the time you retire. Then during your 35 years of retirement it will continue to grow to almost $490k by the time that you reach 100. Due the power of compounding over 70 years from today your original annual retirement budget based on today's costs will have grown almost 5x, or to put it another way in 70 years time, each dollar will only have around 20% of the purchasing power that it does today.
Calculating Your Required Retirement Savings
This is where things start to get a bit more complicated. Let’s assume inflation continues at 2.5% per year and that the annual return on your retirement investments is 4% per year.
As you will see when we look at investing later you can achieve returns higher than 4% in the stock market. However, many people probably prefer a lower level of risk (exposure to stocks) in retirement. Therefore, I have gone with a more conservative figure.
For simplicity I have assumed that our couple want to die broke and not leave any inheritance to their children. Towards the end of this article I will cover how leaving an inheritance impacts retirement planning, but for now let’s keep things simple.
To calculate the required retirement savings, I built a spreadsheet model factoring in compound interest for both inflation and investment returns.
The table below summarizes the output of that model assuming that our couple want to retire on $100k per year, retire at 65 and expect to live until 100.
The scale of those numbers was a huge shock to me when I first built my spreadsheet model, as I am sure they will be for many people reading this article who are new to retirement planning.
The 25x Rule of Thumb
To sense check my model and for comparison let’s take a look at the well known rule of thumb that you should save 25x the income that you would like to have in retirement.
That sounds very straight forward, but the point that is almost always over looked, is that you need to account for the impact of inflation on that income between today and your date of retirement. As we discussed in Step 3 inflation and compound interest can make a huge difference to the numbers over years and decades.
Let’s go back to our $100k example. If we take the 25x rule at face value our couple would require $100,000 x 25 = $2,500,000. If you simply take this amount as your retirement savings target you could be in for a nasty surprise unless you are retiring today.
Lets see how applying inflation between today and the point of retirement impacts the amount that you need to save.
If you are 35 today and plan to retire at 65 (30 years until retirement in the table above) then that $100k budget based on today’s cost of living will have grown to almost $210k by the time you retire. Therefore, you will require retirement savings of almost $5,250,000 (25 x $210k) when you retire in 30 years from today. This number is more than double the $2,500,000 figure that simply applying the 25x rule without accounting for inflation gave us.
If we compare the 25x rule to my spreadsheet model then we can see that my model calculates that around an extra 6% of retirement savings are required to achieve the same level of retirement income.
Based on this comparison and for simplicity you can probably use the 25x rule as a good benchmark for your minimum retirement savings, as long as you remember to factor in inflation between today and the date on which you plan to retire.
Once you have calculated how much savings you want to have at the point of retirement the next action is to take stock and understand what savings and investments you have today. As with budgeting, if you regularly track your savings and investments you will have a head start on this activity. If not, you will have some homework to do.
If you have an employer and/or private pension, then these should be included in your financial assessment. Depending on the retirement rules in your country you may be able to withdraw some or all of the money in your pension when you retire (which you could spend or invest) rather than purchasing an annuity. However, if you are considering this course of action, I would recommend consulting a reputable financial adviser before withdrawing any money from your pension.
If you plan to leave your house to your children as an inheritance, then you should exclude this from your retirement savings assessment. If on the other hand you plan to die broke and not leave any inheritance, which means at some point in retirement you would sell your house so that you can live on the proceeds, or explore some type of equity release scheme where you can take out some of the capital out but remain living in the house, then this should be included in your retirement savings assessment. This decision will have a significant impact on the amount that you need to save for your retirement, which is why it is so important to have the financial conversation that I covered at the outset of this article.
I also would advise being conservative and only including assets that are tangible today. For example, as part of my annual reward my employer allocates me stock units that vest over a number of year. To me these stock units are only tangible (meaning that I can sell them to buy food) once they have vested. Therefore, I exclude all unvested stock units from my financial assessment. Each year when I review and update my financial assessment, I add in any stock units that vested in the last 12 months.
Once you and if you have one your partner have completed your financial assessment you should have a clear view on your current retirement savings and investments. It is also important to understand the type of saving or investment e.g. cash, stocks, unit trusts, bonds, pension, property as each will generate different rate of return.
Where to Invest For and In Retirement
There are two distinct phases of investment and you should understand and the differences between them.
Investing for Retirement: Before you retire you should be focusing on growing your savings. During this time, you can be more aggressive with the proportion of stocks vs bonds in your portfolio. Typically, you would aim to achieve around 8% growth during this phase.
Investing in Retirement: Once you have retired you should be focusing on generating income to live on. During this time you will probably be more conservative with the proportion of stocks vs bonds in your portfolio. Typically, you would aim to achieve around 4% growth during this phase.
This does not have to be a hard cut over on the day of retirement, for example you can gradually transition over several years before and after retirement, and this is where the 100 minus your age rule of thumb comes in.
Simply put, this rule of thumb advises that you should have 100 minus your age as the percentage of stocks in your portfolio with the rest in bonds. Let’s see how this would play out in the table below.
However, as people are in general living longer some financial experts are recommending 110 minus your age or even 120 minus your age as being the more appropriate rule of thumb. This will also relate to your risk tolerance for stock market fluctuations, especially when in retirement.
Only a very small proportion of actively managed funds outperform the stock market, and even fewer of these outperform the stock market consistently year after year. Similarly, few individual investors are consistently able to pick individual stocks that outperform the stock market as a whole.
Therefore, for the majority of investors the best option is to invest in low cost index funds. There are funds which track all of the main indexes, so if you want to invest in a certain region, country or industry there is probably an index fund available.
These index funds are passively rather than actively managed, meaning that the annual fees are much lower. Therefore, as an investor you keep more of the gains. An example of an index fund is the Vanguard S&P 500 Fund (VOO) which tracks the S&P 500 index of the largest companies in the US.
There are also index funds for bonds, so irrespective of whether you are planning to invest in stocks or bonds you should find an index fund that meets your needs.
Retirement Date Target Funds are a special type of fund where the proportion of stocks and bonds is automatically varied based on a target date. An example of these types of funds is the Vanguard Target Retirement Income Fund (VTINX).
I would also recommend the approach of “paying yourself first” as advocated by Robert Kiyosaki in his book Rich Dad Poor Dad. Effectively, what this involves is setting up an automatic investment every month once you have received your salary, before you pay for anything else. This is the opposite of what many people do, which is investing what they have left at the end of the month.
Finally, it is always good to take advantage of any legal tax free savings opportunities where they are available in your country. Similarly, matched pension contributions or employee stock purchase schemes can be a great way to grow your retirement savings if your employer provides these benefits.
Bridging the Retirement Savings Gap
We now know where we stand today and where we want to be at the date of retirement, but how do we bridge the retirement savings gap?
For consistency let’s take our 35 year old couple who would like to retire at 65 and who expect to live until 100. Assuming that they would like a retirement income equivalent to $100k today, we know that it will increase to almost $210k by the time that they retire. Taking my more conservative spreadsheet model rather than the 25x rule of thumb we know that they will need minimum savings of $5,580,000 on the date of their retirement.
Let’s calculate how much this couple’s existing savings and investments will grow to by their date of retirement assuming no further investments are made. Today this couple has savings of $50k in cash, $100k in a bond index fund and $200k in a stock index fund. Assuming cash grows at 0.1%, bonds at 4% and stocks at 8% per year, these existing savings would grow as follows over the next 30 years:
- Cash: $50k x 0.1% pa x 30 years = $52,000
- Bonds: $100k x 4% pa x 30 years = $324,000
- Stocks: $200k x 8% pa x 30 years= $2,012,000
This gives total retirement savings in 30 years time of $2,388,000. Therefore, we can calculate the gap that we need to bridge as follows:
- Total: $5,580,000 — $2,388,000 = $3,192,000
So how can our couple bridge that $3,192,000 savings gap over the next 30 years before their retirement?
For simplicity let’s assume that this couple are comfortable to invest in the stock market through a low cost index tracker generating 8% returns per year, as they are already doing so. In this case this couple would need to invest at least S$2,250 every month in a stock market index fund over the next 30 years to bridge the gap.
In order to calculate this figure, I used an online compound interest calculator combined with some trial and error to find a monthly investment that would result in the desired total after 30 years. There are many online compound interest calculators, but I used this one from Financial Mentor:
But, what can you do if you calculate that you need to invest more each month than you are able to afford. Here are a few recommendations that you can consider to bridge the retirement savings gap:
- Reduce Retirement Budget: By downsizing your Essential Costs and Discretionary Costs you can reduce the amount of retirement savings that you require
- Increase Income: Move to a job with a higher salary, take on a second job or start a side hustle so that you can afford to make the required monthly investments
- Retire Later: By working for a few more years you have more time to accumulate the requirement savings. At the same time this reduces the number of years that you will be retired, reducing the required retirement savings
- Reduce Spending: By reducing the amount that you spend on Essential and Discretionary items while you are saving for your retirement you can afford to make increased monthly investments
- Maximize Returns: Move existing savings/investments to generate higher returns, for examples moving from bonds to stocks. In this way you can reduce the retirement saving gap that you need to bridge. But this also exposes you to greater risks and uncertainty
Practically a combination of several of these recommendations rather than one individual recommendation will probably be the way forwards in bridging the retirement savings gap.
The 4% rule
In addition to the 25x rule and the 100 minus your age rule, the 4% rule is also frequently mentioned with respect to retirement planning.
The 4% rule is a rule of thumb for how much you should take out of your retirement savings in the first year of retirement. Then in each subsequent year you apply inflation (e.g. 2.5%) to the previous years withdrawal so that your income, and therefore your spending power keeps pace with inflation.
So how does this work in practice for our couple who would like to retire at 65 with savings of $5,580,000 when they retire?
In the first year they would withdraw 4% of their savings:
- Year 1: $5,580,000 x 4% = $223,200
In the following 34 years of retirement they would increase the amount that they withdraw by inflation at 2.5% each year as follows:
- Year 2: $223,200 x 102.5% = $228.780
- Year 3: $228.780 x 102.5% = $234,500
- Year 34: $491,879 x 102.5% = $504,196
- Year 35: $504,196 x 102.5% = $516,780
When I compared my spreadsheet model to the 4% rule, I identified that the couple would withdraw less in each year of retirement based on my spreadsheet model than when following the 4% rule. However, it is not that simple.
After 30 years the capital in the 4% rule is completely exhausted. In fact when the 4% rule was created by William P. Bengen in 1994 the average length of retirement was around 20 years. Therefore, a rule of thumb that provided retirement income for 30 years was seen as being realistic and meant that few people would run out of money in retirement. However, with increased life expectancy and the popularity of early retirement this rule of thumb is no longer appropriate today.
With a lower annual withdrawal rate my spreadsheet model would provide inflation linked income for another 5 years, until age 100. To extend the 4% rule to cover another 5 years I calculated that the annual percentage drawn down in the first year would need to be reduced from 4% to 3.6%.
Some financial experts are recommending that a withdrawal rate of 3% or even lower may be more appropriate today.
However, once in retirement you can flex the amount that you withdraw up and down each year to reflect the actual rate of inflation. However, you should avoid the temptation to take out too much, especially in the early years of retirement as this could negatively impact the capital growth over the following years due to the compounding effect.
Leaving an Inheritance
Up to this point I have assumed for the purpose of simplicity that our couple want to die broke and not leave any inheritance to their children. However, I acknowledge that many couples would probably like to leave an inheritance. Either way I would advise having a conversation with your children so that there are no surprises later, even if this may be an uncomfortable conversation for everyone involved.
As discussed in the Financial Assessment section if you plan to leave your house or any other savings/investments to your children as an inheritance then you should exclude these from your retirement savings assessment.
Alternately if you plan not to withdraw all of your retirement savings and to leave an amount as an inheritance then this becomes a more complicated calculation, especially if you have a target amount in mind. Some options that you may consider if this is your intended plan are one or more of the following:
- Retire later so that you are drawing down your savings for fewer years
- Increase your savings before retirement
- Take a part-time job during retirement to reduce the required withdrawals
- Reduce your first year’s withdrawal percentage
- Keep your annual withdrawal increases below the rate of inflation
As you can see deciding to leave an inheritance will require careful planning, consideration and potentially some compromises.
Another point to consider is that inheritance taxes and the legal steps to minimize these taxes vary by country. Therefore, I would recommend speaking to a reputable financial adviser as this is beyond the intended scope of this article.
Finally, I would also advise drawing up a Will so that you can ensure that any inheritance that you leave is apportioned in the way that you desire. In this instance I would recommend speaking to a reputable solicitor who can advise you on the correct steps to create an official Will.
Savings Traps to Avoid
The second piece of advice that I took from Robert Kiyosaki and his book Rich Dad Poor Dad was…
Not how much you earn but how much you keep that is important
If you have a larger income, then there is the potential to save much more than someone with a smaller income. However, there is also the potential to spend significantly more as well.
As people progress in their career and earn more money there is always the temptation to spend more money, this is called lifestyle creep. Being a car guy let me use the car career ladder as an example.
A university graduate starts a new job and after a couple of years upgrades from their first car to a new VW Golf GTi. After a couple more years and promotions they upgrade to a BMW M3. Then a couple of years and promotions later they upgrade again to a Porsche 911. They are earning more money each year as they progress in their career, but they are also spending more each year on a depreciating vehicle.
Here are a few of the big financial traps to avoid that can negatively impact your retirement savings:
- Buying a house with a large mortgage
- Buying an expensive car
- Spending on vacations, restaurants and entertainment
- Buying non-Essential items e.g. designer handbags, luxury watches/jewelry, the latest OLED television or the newest iPhone
- Incurring credit card fees by not paying off the full balance every month
- Having an expensive wedding and honeymoon, followed by an even more expense divorce
- Sending your children to private schools with high annual fees
I am not advocating that you do not treat yourself occasionally, but it is all about balance. You want to have a good life both before and after retirement. As the famous investor Warren Buffet said…
“It’s nice to have a lot of money, but you don’t want to keep it around forever. I prefer buying things. Otherwise, it’s a little like saving sex for your old age.”
Spending too much today and saving too little while you are working can negatively impact your retirement. Similarly, being too frugal now so that you can have a comfortable retirement later, is probably not ideal either. It is all about finding a balance that is right for you.
I hope that the advice and explanations shared in this article will be of assistance to you as you plan for your own retirement. With that in mind I would like to summarize a few key points:
- Have an early conversation to understand your retirement goals
- Define a realistic retirement budget and retirement savings target allowing for the impact of inflation
- Assess where you are today financially and plan how to bridge the retirement savings gap
- Start investing early to maximize the benefits of compound interest
- Invest in low fee index funds rather than actively managed/high fee unit trusts
- Set up automatic investments every month and don’t ever take the money out after you have invested it
- Plan carefully and consider how it will impact your retirement if you plan to leave an inheritance
- Avoid the financial traps of buying a large house or an expensive car
- Continue reviewing your progress on an annual basis and adjust your investments as required
- Find a balance between enjoying life today and investing for your retirement tomorrow as no one knows what the future holds
It is important to remember that even a small change in the inflation rate or rate of return on investments can have a huge impact due to the power of compounding, especially over multiple decades. Therefore, you should always use the percentages that you feel comfortable with when planning for your own retirement.
In conclusion, if you calculate your required annual income in retirement and then apply the 25x rule taking inflation into account, and only draw down 3.5% in the first year followed by inflation linked amounts in the following years you will be able to calculate the minimum savings that you should aim for in order to enable the retirement that you aspire to have. However, if you want to be more conservative in your retirement planning you can aim for 33x or more of your inflation adjusted annual income and/or you can aim to withdraw 3% or less in the first year of retirement.
If you are interested to explore the topic of retirement planning in more detail then I can recommend these articles and videos as great ways to further your knowledge of this important subject:
- The Multiply By 25 Rule and 4 Percent Retirement Rule
- Warren Buffett’s Best Investment Advice: Buy Index Funds
- These numbers show Suze Orman is right about needing $5 million to retire
- A woman who retired early at 38 says 4 strategies can help anyone save big without pinching pennies
- I retired at 37 as a self-made millionaire - here’s how I figured out exactly how much I needed to save
- Can YOU Afford to Retire? | 4% Rule Explained | Safe Withdrawal Rate