What should I have for dinner tonight? What movie should we go see? Where should we go on vacation this year? Many questions in life are relatively easy to answer. But if you’re wondering, “Am I on track for retirement?” it may quickly turn into a frustrating exercise.
To know the answer, you also need to know or decide things like when you should retire, whether you want to fully retire or pursue an encore career, what investment returns you can expect and what percentage of your income you should plan to live on. The list of unknowns goes on and on.
Fortunately, research from financial planning expert and author Craig Israelsen offers another way to think about how much you’ll need to have on hand for a successful retirement.
The 4% rule
The most common rule of thumb, the “4% Rule,” is a great place to start, but it doesn’t tell the whole story -- especially if your retirement is far off.
The 4% rule holds that retirees can safely withdraw 4% from their retirement savings investment portfolios each year without running out of money. The actual percentage varies for everyone, with some retirees needing to withdraw a smaller percentage to never run out of money, while others can withdraw even more, particularly if they choose to work into their 70s.
In a retirement-planning context, you would want to save enough so that drawing on 4% of your retirement portfolio each year would supplement your other retirement income, such as Social Security benefits or annuity or pension payments, to cover your projected retirement budget.
For example, let’s say you and your spouse set a budget of $80,000 a year and have $1 million saved for retirement. The 4% rule says you can safely withdraw 4% of this balance, or $40,000. Then look at your Social Security benefits. If you and your spouse are each projected to receive $2,000 a month, or a total of $48,000 a year, you’ll have a total of $88,000 -- safely above your $80,000 budget.
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The 4% rule can be helpful for those at or near retirement, but what if you’re in your 40s or 50s? Israelsen’s research could give people in this younger age bracket a way to think about whether they are on track for retirement.
The author focuses on the concept of a “retirement account multiple,” or RAM, which is the amount of money you’ve saved for retirement as a multiple of your final salary. So, for example, if you’ve saved $500,000 for retirement and your final salary is $100,000, you have a RAM of 5. Israelsen researched the RAM level you need to reach if you want to be able to:
- Withdraw half of your final salary each year to live on.
- Give yourself a 3% raise every year to account for inflation.
- Retire at age 65 and have money to live on through age 100.
Israelsen cranked through 90 years of historical data from 1926 to 2015 and concluded that investors who want to retire at age 65 should target a final RAM of 7 to 18. A RAM above 7 means you’re in decent shape, and a RAM of 18 means you’ve protected against the absolute worst that the markets have had to offer in historical terms.
If you retired between 1926 and 2015 at age 65 with a RAM of 7 and lived to 100, you’d have a 71% chance of never running out of money. (This assumes you also continued to invest in a traditional portfolio of 65% stocks and 35% bonds during your retirement years.) And if you managed to save enough to have a RAM of 18 and retired at any time in that 90-year span, you’d never run out of money through age 100.
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So here’s where you and your math brain come in. If you want to retire at 65 under the conditions listed above, here’s a quick, back-of-the-envelope way to check how you are doing, no matter what age you are.
First, calculate your projected final salary, as follows:
Final Salary = Current Salary x ( 1.03)^(65 – Current Age)
This assumes you’re getting a salary bump at the rate of inflation. (Note that the little caret symbol means raised to this power. It is raised to the nth power to carry the inflation factor forward across multiple years.)
Then, calculate your projected final account balance. For this example, let’s assume you earn an annual average of 7% on your investments (net of all fees and advisory expenses) between now and when you retire. Your projected retirement account balance is:
Final Retirement Savings = Current Savings x (1.07)^(65 – Current Age)
Finally, calculate your projected RAM, which is:
Projected RAM = Final Retirement Savings / Final Salary
Here’s an example of how it works. Let’s say that you’ve risen in your career, you are 50 years old and you’re making $100,000 a year. You’ve been a diligent saver, and you have $400,000 saved for retirement.
- Final Salary = $100,000 x (1.03)^15 = $155,797
- Final Retirement Savings = $400,000 x (1.07)^15 = $1,103,613
- Projected RAM = $1,103,613 / $155,797 = 7.08
This projected RAM barely puts you in the safe RAM retirement zone of 7 to 18.
Are you on track?
Now you can figure out your projected RAM using the method listed above. If you get an answer of 12 or more, you’re in great shape for retirement. Moving from a RAM of 7 to a RAM of 12 is a meaningful difference in terms of your retirement security and protection against bad markets. For me, if I’m at a 12, instead of chasing down a RAM of 18, I’d rather enjoy a higher standard of living today and leave more to my favorite causes than pile up a bunch of extra money that I probably won’t need.
If you’re between 7 and 12, you’ll be able to get by at your current rate of savings, but you may need to reduce your standard of living if we hit an extended rough patch in the markets early in your retirement. And if you’re projecting a RAM of less than 7, you may want to strongly consider increasing your savings rate or finding other ways to supplement your income.
In fact, note that a big item we haven’t accounted for in this calculation is how much you plan to save in the years leading up to retirement. If you continue to save and invest, you can expect your RAM to tick upward. Figure your projected savings with this equation:
Extra Retirement Savings = [(Current Salary + Final Salary)/2] x (Savings Rate) x (65-Current Age)
Add the sum to the final retirement savings calculated above for an idea of your savings at retirement. And this doesn’t include your future investment growth; compounding interest will boost your totals further.
These calculations won’t be exact, since there are many assumptions about unknowns and many possible outcomes between now and the time you retire. Even so, this method gives savers in their 40s and 50s another tool to get a sense of whether they are on track for retirement. So get out your calculator.
Dave Rowan is a certified financial planner and the founder of Rowan Financial. He is an advisor at NerdWallet, a personal finance website.
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