Have I saved enough to retire, or do I need to keep working?

Here’s a simple formula.

Photo: Taken by the author, the shoes on the right are mine, from our balcony on Cunard Line’s Queen Mary 2, somewhere in the mid-Atlantic.

I was ready. Had I saved enough, or did I need to keep working?

A financial advisor gave me a tedious 20-page form that took hours to complete. I struggled for days trying to figure out how much I spend on dry cleaning and groceries, restaurants and theater tickets. I tried valiantly to remember my passwords for the telephone and electric bills. It was agony.

That financial advisor will rue the day he met me. You see, I’m an economist by training, with a Ph.D. appended to my name whenever I want to avoid providing actual facts to back up my arguments. While there’s actually nothing relevant that an economist has to offer to this discussion, we do tend to be handy with a spreadsheet, and we have about as much common sense as the next academic. I told that financial advisor, in so many words, he was wasting my time and elevating my blood pressure.

For the problem of retirement savings, I eventually decided that a method of differences would be the most handy. That is, instead of trying to imagine my new retirement financial life from scratch, I would simply ask what is likely to be different in retirement. It turns out this method of differences worked pretty well for me. Perhaps it will suit you, too.

One more thought before diving in: You’ll see some formulas and some strings of letters (aka “variables”) below. I’m an economist, with a Ph.D., which of course is irrelevant, but it means I simply can’t help myself. If you don’t like formulas and variables, ignore!

Step 1: What do I want to take home in retirement?

MTHPIR = MTHPWW - WRE + NRE

As a starting point to figure out how much money I need in retirement, I use my monthly take-home pay while working (MTHPWW). I use take-home pay, not full salary. I was paid every two weeks. I convert this to a monthly figure, multiplying by 26 and then dividing by 12.

I make a few adjustments, because some things are different in retirement. There are work-related expenses (WRE) I had to pay out of my take-home pay while working that I will not have to pay once I’m retired (dry cleaning, the daily commuter fare). Some people also have new retirement expenditures (NRE) such as health insurance that were covered by their employer while working, particularly if they’re retiring “early” and not yet old enough for Medicare. I do not account for taxes just yet, but will do that below.

Using this method of differences, I thus adjust my monthly take-home pay while working (MTHPWW) to derive my desired monthly take-home pay in retirement (MTHPIR). The assumption at this juncture is that I want to keep on living more or less the same as always, at least financially, but I acknowledge that just a few things will be different.

Step 2: How Much Will I Need Monthly From Retirement Savings?

MDRS = MTHPIR - P

My income in retirement will be partly from savings, and partly from pensions (P = P1 + P2 + P3 …) of various kinds. Pensions are basically funds from which (usually) monthly payments are received, often for life. Sometimes they’re called “annuities”. I have a traditional pension, sometimes called a “defined benefit plan”. If you don’t have one, and if you’re able, consider switching to an employer who provides one. They’re really very nice.

When I turn 62, I’ll start drawing Social Security, which is essentially a second pension. I also had a generous relative who left a small trust, which pays my family a bit every year. It’s like having still another pension. I divide that annual trust payment by 12 and add it in, too. In your case, add in whatever non-savings sources of monthly income you expect to have, including any job income after “retirement”.

Since pensions (and maybe a part-time job greeting people at Walmart) won’t be enough, I’ll draw the rest from savings. The monthly draw on retirement savings (MDRS) will have to be equal to my monthly take-home pay in retirement (MTHPIR) minus income from my various forms of retirement jobs and pensions (P).

Photo: The author’s desk.

Step 3: How Big Does My Retirement Fund Need To Be?

RF = (MDRS x 12)/DP x (1 + TAX)

Do I have enough in my retirement fund? How much is enough?

My savings are invested in stocks (mostly), and so earn dividends that are placed back into more stocks. The stocks themselves grow in value as the value of their underlying companies increases.

Let’s say I have $1 million invested. Every year, those funds grow by about 7%, sometimes a bit more, sometimes a bit less. I take 4% out. That means the fund is 3% bigger at the end of the year than at the beginning, even though I took a bit out.

The amount I decide to take out of my investments is the draw percentage (DP). In the example above, it is 4%. That’s actually a fairly standard number, often recommended by financial planners, though some suggest 5%, while others say 3%. There’s a lot behind that number., mostly having to do with inflation and risk, which I won’t go into now. My research suggests 4% is a good number, but I’ll be keeping an eye on my investments, and will make further adjustments later as I see actual performance.

Once I’ve settled on my draw percentage (DP), and know my monthly draw on retirement savings (MDRS), I can answer the question that kicked off this section. I simply multiply my monthly draw on retirement savings (MDRS) by 12 to get the annual amount. I then divide by the draw percentage (DP).

Finally, I add a cushion for taxes. I use 25%, which for me might be too much. Some may find it surprising that the actual tax rate in retirement is often the same as while working, or just a bit lower. For planning, it doesn’t hurt to overestimate.

An Example, Not Really True, But Maybe Useful

Suppose my monthly take-home pay while working (MTHPWW) was $5000. I subtract monthly work-related expenditures (WRE) that were previously paid out of my take-home pay. These were for dry cleaning ($200) and for my commute ($500), leaving $4300. I also paid for lunch at a cafe every day while working, but I might continue to do this in retirement — it would thus not be a “difference” — so do not include that in my calculation here.

I add back in my one significant expected new retirement expenditure (NRE), health insurance, which in my case is $0 since my employer will continue to pay its part of my health insurance even in retirement (lucky me!). Thus my desired monthly take-home pay in retirement, (MTHPIR) is $4300.

I will be receiving a traditional pension of $1100 per month, plus Social Security of about $900 a month, and a small trust payment of $400 a month, totaling $2400 per month. I subtract this from my monthly take-home pay in retirement (MTHPIR) of $4300, leaving $1900 per month that will be my monthly draw from retirement savings (MDRS).

How big does my retirement fund (RF) need to be? I multiply the $1900 monthly draw from retirement savings (MDRS) by 12 to get the annual draw, which is $22,800. I then divide by my draw percentage of 4%, yielding $570,000. Finally multiply by 1.25 for 25% taxes, to get the necessary amount of the retirement fund (RF), $712,500.

If I have that much in my fund, I can retire with much the same lifestyle as I had while working. If not, I either need to keep working, or I can find ways to reduce my living expenses — create more “differences” — like maybe moving into a mobile home in rural Mississippi, or perhaps a cabana in Belize, but generally someplace where there’s no opera company.

In this example, which is true of someone who is not me, the fund is too small, so he’s not ready to retire. He’ll keep working.

Some younger people may ask — I do encourage such questions, especially from woeful millennials — is there any hope? Of course! Just put 15 cents of every dollar you earn into an investment fund, or make sure someone else is doing it in your behalf. No excuses. You’ll be ready to retire sooner than you think. More on that later.

Jeff Cochrane holds a doctorate in applied and agricultural economics from the University of Wisconsin-Madison, and is also a pensioner under the Foreign Service Pension System. He is retired from the U.S. Foreign Service, having spent the bulk of his career directing economic programs of the U.S. Agency for International Development. He is not a financial advisor or certified financial planner, and nothing in this article should be construed as offering specific advice to individuals about trading securities.