There are a lot of suggested ways to calculate the amount of money you need to have in retirement savings in order to comfortably retire. The problem with most of them is that they are overly simplistic and do not take into account the nuances that each of our individual circumstances bring. Rules such as you need “10 times your annual salary” or “25 times your annual spending” can result in either underfunding your retirement portfolio or overfunding your retirement portfolio. The result of the former is that you will outlive your retirement savings, the result of the latter is that you will be funding a million dollar funeral. I have created an Excel spreadsheet that allows you to calculate the amount you need to save for retirement each year in order to maintain your current disposable income. You can download the spreadsheet with it pre-filled with an example using the average income for a general internist by clicking here:

Retirement Savings Calculator Example 1

Instructions on how to enter data into the spreadsheet can be downloaded by clicking here to download the Word document:

Retirement Savings Calculator Instructions

This blog post will explain the background for this calculator. Because life is complex, calculating your retirement needs are complex, so reading this post may seem overwhelming. However, this calculator takes most of the complexity into consideration to allow you to arrive at a reasonably accurate number with relatively little effort. I encourage you to download the Excel spreadsheet and play around with the numbers based on your own particular financial circumstances.

### Building your retirement portfolio

There are two ways you can increase the amount of money in your retirement portfolio: (1) save more money each year or (2) work more years. Followers of the FIRE movement (Financial Independence Retire Early) will tell you to put more money away early in your career so that you can retire as soon as possible. There are two problems with this approach. First, excessively increasing your retirement savings in your youth reduces your disposable income and forces you to live austerely when you are young thus sacrificing quality of life. Second, the FIRE approach assumes that working is unpleasant and something to stop doing as soon as possible. My own opinion is that if that is the case, then you made a wrong career decision and have an unrewarding job that you are not passionate about.

The second way to increase your retirement portfolio is to work past the age that you planned on retiring. This may be totally acceptable if you are continuing to work because your job is fulfilling and you would rather be engaged in your career than be retired. On the other hand, working past your planned retirement age simply because you cannot afford to retire can result in you working in a career that you are not passionate about and missing out on doing the things you dreamed of doing in retirement when you are still healthy enough to do those things.

Thus, the goal of retirement saving is not to be rich *monetarily*, but to ensure that you can have a rich* life*, both while you are working and in retirement. In this post, you will learn how to calculate the amount you will need to save each year while you are working in order to meet your financial needs in retirement and ensure that you do not run out of money as you get older.

### First, determine your current disposable income

Your disposable income is your annual income after you have paid all of your taxes and after you have paid expenses that you will have in your working years but not in your retirement years. Your taxes will include federal income tax, state income tax, local income tax, and FICA tax (composed of Medicare plus Social Security tax). The easiest way to get these values is from last year’s W-2 forms and IRS 1040 forms. You can also calculate these by using an online calculator such as the SmartAsset calculator and entering your total salary, filing status, number of dependents, geographic location, and deferred income contributions to calculate all of your various taxes.

Expenses that you will have during working years include retirement savings, mortgage payments, children’s college savings, and life insurance. Hopefully, once you are retired, your house will be paid off and your children out of college. As I have written in previous posts, I am not in favor of buying whole life insurance and instead, prefer buying term life insurance but only during the *term* of years that others depend on your income – once you are retired and drawing from your retirement accounts, you no longer need to purchase life insurance.

The amount of money left over after subtracting taxes and working year expenses is your annual disposable income. This is the money that you use to pay for food, housing upkeep, travel, clothes, entertainment, utilities, property taxes, healthcare, etc. These are purchases and expenses that you will have in both your working years as well as your retirement years. A major goal of retirement savings is to ensure that you have sufficient money to cover at least this same amount of disposable income once retired.

The amount of your current disposable income will need to be adjusted for inflation in order to calculate the amount of disposable income you will need when retired. Although it is impossible to predict exactly what the future inflation rates will be each year between now and your retirement, historically, inflation runs about 3.5% every year on average. In other words, what costs you $100.00 today will cost you $103.50 a year from now. By adjusting for inflation, you can maintain a constant purchasing power with your disposable income.

Many retirees will have new expenditures in retirement years that they do not have during working years, such as travel, a second home, a boat, etc. If you plan on doing any of these things, then add an annual amount to your retirement year disposable income – for example, if you plan on spending $30,000 per year in retirement traveling, then add $30,000 to your retirement disposable income. This amount will also need to be adjusted for the effects of inflation between now and when you retire.

### Second, calculate your fixed income in retirement

The most common retirement fixed income is Social Security. The average American’s Social Security benefit is $20,000 per year and the maximum is about $40,000 per year. However, to get the higher amount, a person would need to have a very high income, contribute to Social Security for 35 years, and wait until after age 70 to begin taking Social Security benefits. The second form of fixed income is the pension. In the past, many Americans relied on pensions but these are increasingly uncommon for non-government employers. However, physicians employed by state supported universities and federal government agencies may have access to pensions through their State Teacher’s Retirement System or through the Federal Employees Retirement System. The third type of fixed income is the annuity which is essentially a self-funded pension sold by an insurance company.

In order to calculate the amount of money you will receive from fixed income sources, you can check your annual Social Security statement or pension statement. Social Security benefits have increased an average of 2.6% per year for the past 36 years so adjust your actual Social Security benefit for these anticipated cost of living increases in the years before you retire.

### Third, determine the amount you will have in your investment portfolio when you retire

To calculate the value of your retirement portfolio in the year that you will retire, you will need to estimate the number of years until your retirement. Next, determine the amount of money in all of your retirement accounts at the end of the last calendar year. Finally, determine the total amount you are contributing to retirement this year – this should include all deferred income accounts (401k, 403b, 457, 415m, SEP, and IRAs), all employer matching retirement contributions, and all regular investments used for retirement saving. Because a person’s income will usually increase as inflation increases, it is expected that the amount contributed to retirement savings will also increase, proportionate to the increase in income each year. As such, the IRS periodically increases the annual maximum contribution limits for deferred income accounts and historically, this increase has averaged 3.0% per year over the past 36 years. Therefore, you can assume increasing your retirement contributions by 3% each year.

Because your retirement savings will be invested, you will need to estimate the annual rate of return that you expect during your working years. Historically, over the past 94 years, the average annual rate of return of bonds has been 5.33% and the average return of stocks has been 10.29%. Portfolios containing a mix of stocks plus bonds over this period of time have average annual returns falling in-between as shown in this table.

Historically, a common retirement investment portfolio of 70% stocks and 30% bonds has an average 9.2% annual return on investment. In reality, most investors will have a higher percentage of stocks in their retirement portfolio early in their careers and a lower percentage of stocks in their late careers. However, a 70%/30% mix is convenient to represent the average mix over the course of one’s entire working years. Not all stock investments have equal rates of return, however. Because of their higher expense, managed mutual funds will have lower net returns than low-cost index funds. Also, if you hire a wealth adviser to manage your portfolio, their fees will reduce your returns. In these situations, you should reduce your expected annual return by 1-2%.

The reason for the change in the stock:bond ratio with age is because stocks are far more volatile than bonds and are more likely to lose money in the *short run*, even though they are more likely to make money in the *long run*. As a person gets closer to retirement age, the risk that a retirement portfolio comprised of stocks will fall in the next few years because greater volatility increases and this could result in you having to withdraw money from your portfolio when the value of the portfolio is lower, thus depleting your retirement savings faster. From the graph below, if a person held stocks in 2000, the subsequent fall in the stock market resulted in the value of those stocks not recovering to the break-even value until 2007. Thus, a person retiring in 2000 with a retirement portfolio consisting primarily of stocks suffered a catastrophic loss of their retirement savings.

Not only will the ratio of stocks:bonds in your retirement portfolio change as you get older, but the ratio is also affected by your individual ability to accept investment risk. This risk assessment is affected by many factors including:

**Anxiety created by market volatility.**If you lose sleep when stock prices fluctuate or if falling stock prices make you want to sell your shares, then you should adopt a low-risk portfolio.**Optimist or pessimist?**If you believe that the United States’ best years are behind us, if you are pessimistic about the economy or geopolitics, then you should adopt a low-risk portfolio.**Pensions.**If you have a pension, then a sizable portion of your retirement portfolio will be a non-volatile, dependable amount of income. This gives you the luxury of having a higher percentage of more volatile stocks in your other investments since the stability of the pension will substitute for the stability of bonds allowing you to have a higher-risk portfolio. Notably, state government institutions (including public universities) usually do not participate in Social Security and if their employees elect to self-direct their retirement contributions (rather than participate in the state teachers retirement system or public employees retirement system), then those employees will have no Social Security and no fixed income in retirement – these employees should choose a lower-risk portfolio because of the lack of a fixed income buffer to their retirement income.**Anticipated life expectancy.**If you anticipate living many years in retirement, then your investment horizon is longer and you can afford to have a higher-risk portfolio. If your life expectancy after retirement is shorter, then it is safer to favor the stability of a lower-risk portfolio.**Annual living expenses.**If your projected disposable income in retirement is very close to your projected living expenses, then you cannot afford the volatility of a portfolio comprised mostly of stocks and instead should favor the predictability of a lower-risk portfolio.

Here is an example of how to structure a retirement portfolio based on both age and risk assessment:

### Fourth, determine the annual withdrawals from your retirement portfolio to achieve your desired disposable income

In your retirement years, your deferred income distributions, fixed income, and annuity income will all be subject to federal and state income tax (except for Roth accounts). Inevitably, income tax rates will go up and go down on different years when you are retired so it is not possible to accurately predict what your income tax rates will be in any given retirement year. The most conservative estimate is to use your current federal and state income tax rates. Once you calculate your desired disposable income in the first year of retirement, you can then calculate the amount of income tax that you will have to pay on fixed income sources and deferred income accounts in order to fund that desired disposable income.

In each year of retirement, inflation will result in an increase in the amount of money that you will need in order to maintain a constant purchasing power from your disposable income. Inflation rates will inevitably be higher in some of your retirement years and lower in other years but for convenience, use the historical average annual inflation rate of 3.5% per year. In addition, your retirement portfolio will increase each year based on your annual rate of return on the investments. Once again, it is impossible to know with certainty what your rate of return will be but if you assume a 50% stock and 50% bond mix in your retirement portfolio in the years after you retire, then based on historical rates of return, you can assume an 8.3% average increase in the value of your portfolio. The goal is to ensure that your investment rate of return exceeds the inflation rate, otherwise, your portfolio will lose purchasing power every year.

By estimating the value of your retirement portfolio at the time of your retirement, estimating how much you will need to withdraw from that portfolio each year to achieve your disposable income needs, estimating the inflation rate during your retirement years, and estimating the rate of return on your retirement portfolio investments, you can calculate how many years your retirement portfolio will last. In order to determine if it will last long enough, you will need to estimate your life expectancy (and your spouse’s).

According to the CDC, the life expectancy from birth is 77.0 years. However, this is not an accurate number to use in calculating how long your retirement portfolio needs to last. The problem is that a lot of people die between birth and age 65 and this brings the average life expectancy from birth number down. What you are interested in is how long you will live *after* age 65 since you are assuming you will not die before retirement. The average life expectancy for 65-year-old Americans in 2019 was 83.2 years for men and 85.8 years for women. In 2020, those life expectancy numbers dropped by an average of 1 year due to excessive deaths from COVID. Assuming COVID is now largely behind us, the 2019 life expectancy numbers are probably more valid than the 2020 numbers. But remember, these life expectancy numbers are an *average* and therefore, half of 65-year-olds will live longer than the average. To be conservative (and optimistic!), I recommend using a life expectancy of 95-years-old for financial planning purposes and then adjust that number up if you have a family history of longevity and you have no major medical problems. Adjust the number down if you have chronic medical conditions, if you are a smoker, or if you are unvaccinated. As an example, if you plan to retire at age 65, you should plan on funding 30 years in retirement (to age 95).

### Fifth, determine the effect of changing your annual retirement contributions

If you calculate that your retirement portfolio will run out of money before your estimated age of death, then increase the amount you will contribute to your retirement portfolio this year and re-run the numbers until you estimate that you have enough to last for your entire estimated life. On the other hand, if you find that your retirement portfolio will still be large on your estimated death age, then scale back your annual retirement contributions or increase your desired annual disposable income in retirement and re-run the numbers.

### Knowledge is freedom

To calculate the amount of money you need takes time and is complicated. The downloadable retirement calculator attached to this post can help and will probably take about 20 minutes once you assemble your current financial documents. However, doing the calculations can bring you the security to ensure that you do not run out of money in your retirement years and the security of knowing that you will be able to do all of the things that you dream of doing once retired. But most importantly, it gives you freedom – freedom to work in your 60’s or 70’s because you *want* to work and not because you *have* to work.

March 26, 2022