The 3 “hows” of Retirement

Photo by Stéphane Delval on Unsplash

We live busy lives.

Especially if you have a full-time job. 25 years ago, when all you had was a landline and Maybe a desktop computer in your office, once you left the office for the day the only way a work-related issue could reach you was for someone to call your home phone. This would require someone to have your phone number and the nerve to call you at home after hours. Once the workday ended you could forget about work until you punched back in the next day.

With the gift and curse of technology like smartphones, tablets, and laptops you are always within three feet of your company phone or email. You are always available.

If you are a parent and have a full-time job you are even busier. Between taking work calls and e-mails you must drive the kids to and from sports practice, after-school activities, swimming lessons. Making sure your kids are doing their homework, doing laundry the number of activities goes on and on.

If you are a frugal parent with a full-time job you are busier than anyone. Not only are you answering work phone calls between taking your kids to swimming lessons and all the other duties of the full time employed parent, but you are doing it all yourself. If you are a frugal parent;

The point is we live extremely busy lives filled with constant and immediate decisions we must make. That is mentally draining and once we have completed all the tasks for the day, all we want to do is kick our feet up for 45 minutes with a glass of wine and settle into a trashy show on Netflix. The last thing most people want to think about in ever-dwindling amount of free time is whether they are on track to meet their retirement goals.

That is why 45% of Americans have not saved one penny towards retirement. Unfortunately, unless you have bigtime bucks to invest, it can be difficult to find a financial advisor who will hold your hand and walk you through the process of figuring out the three How’s of retirement.

  • How much money you’ll need in order to retire?
  • How you’ll save that money and;
  • How to ensure you don’t run out of money in retirement

How Much Money Do I Need?

The critical question that will determine how much you need to retire is how much you’ll plan on spending in retirement.

People tend to underestimate how much money they will need in retirement. Put aside the fact that people fail to account for how much their medical costs will increase in retirement. We forget a very simple truth. More free time = more opportunity to spend money.

If you think about it, we spend 40+ hours a week engaged in a very inexpensive activity. It’s called work. While at work we don’t have the opportunity to spend a lot of money. We spend most of our money on weekends and vacation. What happens when every day is a weekend or vacation? You’ll end up spending more money.

The Wall Street Journal developed an online retirement calculator that will help you answer the question “how much money will I need in retirement?”

The brilliance in this calculator is that the only requirement is to answer questions like “how often you would like to eat at restaurants?” or “how many magazine subscriptions would you like to have?” You don’t need to estimate how much these things cost, they do that for you. The only thing you need to decide is how often you would like to do engage in each activity during retirement.

The calculator will tell you;

  • What percentage of your income you would need during retirement?
  • How much money you would need to save to fund that retirement.

If you are looking for a quick and dirty way to get a ballpark figure of how much you’ll need, the rule of 25 times, is helpful. The 25 times rule is quite simple, it states that you need to save 25 times your annual expenses to retire. Note that is not 25 times your annual income, but 25 times your annual spending.

If you think you’ll spend $50,000 in retirement than you would need about $1,250,000 ($50,000 X 25) to fully fund your retirement.

How You’ll Save That Much Money

You might be reeling from sticker shock. $1.25 million seems like a hell of a lot of money to fund a $50,000 per year retirement.

Do you have a defined benefit pension plan at work?

If yes, you’ll be fine. Count yourself lucky because you are in the vast minority of workers. Talk to your pension plan provider or a financial advisor so you know how much your pension will cover in retirement and when you can retire.

If no, my next question

Do you have a 401k at work?

While not as ideal as a defined benefit pension plan, a 401k or a Defined Contribution pension plan is more than adequate to help fund your retirement IF YOU UTILIZE IT.

A 401(k) is a kind of defined contribution pension. You deposit money into the account and your employer will match the money you deposit up to a certain limit. Usually 5% of your salary. Another critical thing to understand about your 401(k) is that you must choose how to invest the money in the plan.

A 401k works simply. You make a tax-deductible contribution into the account; your employer matches that contribution (usually up to a maximum of 5% of your salary) and then you decide how to invest that money. It is a boring but efficient way to become a millionaire.

If you make $100,000 per year and you contribute $5,000 into your 401(k), your employer will also deposit $5,000 on your behalf (5% of your salary). You just doubled your money by literally doing nothing.

This employer match makes a huge difference over the course of your working life. The difference between investing $5,000 per year and $10,000 per year amounts to over $500,000 over a 30-year period. Over a 40-year period, the difference is $1,000,000.

I highly recommend you check out this article that explains in more detail how to leverage your 401k into making you a millionaire.

You should be thinking, “hey, that’s almost enough money to fund my $50,000 per year retirement”. Things are not looking so hopeless after all. Between a well managed 401k and owning a fully paid off home by the time you hit retirement age, you’ll be just about at that $1.25 million (or whatever that number is for you) that you’ll need to fund your retirement.

Now that you have a plan in place to figure out how much you need to retire, how you’ll save that money to fund your retirement, only one question remains.

How You’ll Ensure You Don’t Outlive Your Money

The simplest way to ensure you don’t run out of money in retirement is to buy an annuity. An annuity is a contract between you and an insurance company in which you make a lump sum payment, (AKA your retirement savings) to the insurance company and in exchange, they make a series of monthly payments back to you.

People use annuities to ensure they have a predictable stream of income during retirement. The problem with annuities is that for retail investors (you and I) they are very expensive. The fees can take a big bite out of your retirement savings.

For the fee conscious, DIY investor, the alternative to annuities is the 4% rule. The 4% withdrawal rate refers to how much of your retirement portfolio you liquidate in the first year of retirement. It works in direct connection with the “25 times rule”.

Using our example of needing to save $1.25 million to fund a $50,000 per year retirement. The 4% rule says in the first year of retirement you withdraw $50,000 (4% of $1.25 million).

In the second year of retirement, you withdraw $50,000 plus inflation. You continue in this manner for the rest of your retirement.

Be aware, that 4% rule is not foolproof. It assumes that you can receive an average return on your retirement savings of at least 4% above inflation. To achieve that, you’ll likely need to be aggressive in your investing.

This opens you up to what is called “Sequence of returns risk”. Imagine you were about to retire in 2008. You’ve saved up your $1.25 million, you are all set to use the 4% rule and then the financial crisis hits. Your $1.25 million is now only worth $600,000.

If you were to retire at that time, you could only safely withdraw $24,000 in your first year of retirement. That dream of $50,000 went right out the window.

Making sure you don’t outlive your money is the most difficult part of retirement planning. This is the reason many people are willing to pay the extremely high fees involved with annuities. It might hurt to pay those fees, but in doing so you are transferring that sequence of return risk from yourself onto the insurance company.

That is a decision each of us must make for ourselves.

Below is an extended discussion of the “4% rule” and the “25 times rule”

A vlog of yours truly discussing the 4%- and 25-Times rules

So, what do you think about the “three how’s” of retirement? Do you have questions, is there another ‘how” that I should have addressed?

This article is for informational purposes only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.