How Much Savings Is Enough?

Aug 1, 2013 by


Retirement Ahead road signLen Penzo is running a series on his blog called “How I Live on Less than $40,000 Annually.” He finds people from different geographic areas and circumstances and lets them explain how they live while spending less than $40k per year.

Could You Live on $40,000 a Year in Retirement?

Len’s series made me think about whether some people could live on $40,000 or less in retirement. Many aren’t going to have a choice, so it seems. Then I wondered how large a nest egg one would need to withdraw $40,000 a year and run little risk of running out of money. The answer depends on many future variables, but I isolated two important ones—future inflation and the return earned on savings—and created this graph (which I like to do):

graph depicting how long a nest egg lasts

The three lines show three different starting nest egg sizes: $1 million, $500,000, and $250,000. Then to take into account both inflation and return on the invested nest egg, I plotted real return on investment across the bottom and years until the nest egg is gone on the vertical axis (or “y” axis for you engineers). “Real” simply means after inflation. Example:

Inflation during your retirement years: 2%

Return you earn on your savings: 5%

Real return on investment = 5% − 2% = 3%

So plug in your own expectations. Note that real returns can be negative if you expect inflation to outpace your investment returns.

How Much Can You Withdraw to Make Your Nest Egg Last 30 Years?

Now let’s ask the same question a bit differently. Given a $1 million, $500k, or $250k  nest egg, how much can you withdraw annually to make your savings last 30 years? Here you go.

graph showing how much I can withdraw from savings

Again based on your assumptions for a real rate of return on your savings, this graph shows the most you can withdraw each year to make the nest egg last 30 years. In the example, you could withdraw $28,400 annually from a $500,000 nest egg that earned a 4% annual real rate of return over the 30 years.

How to Use the Graphs in the Real World

You can of course retire from your full-time career whenever you want, but information like this will give you a sense of how much extra income you’ll need to supplement withdrawals from your nest egg to meet your living expenses, whatever they may be. You’ll be getting Social Security (or the equivalent if you live outside of the U.S.) we hope, but if there’s still a deficit in your household budget, you’ll have to keep earning to fill the gap, change your lifestyle to spend less, or both.

A BIG Caveat

As you may have noticed, stocks have become quite crash-prone over the past 15 years. The problem with an analysis like the above is it implicitly assumes everything happens smoothly and regularly. In particular, the average annual real investment return is assumed to happen each and every year of the graph’s time horizon. We know that’s not how things work in the real world.

Let’s say for you year 1 in the first graph was 2007. (For millions of people, it was.) You may have seen your $1,000,000 nest egg “Wall Streeted” to $600,000 by early 2009. Would you have then had the nerve to continue withdrawing, say, $50,000 annually? I wouldn’t have. Stocks have recovered, but if they hadn’t you would have “jumped lines” so to speak on the first graph, suddenly finding yourself on a trajectory that would exhaust your badly cracked nest egg long before the age to which you hope to live.

You may draw your own lesson from the past five years, but for me it’s aim to build a nest egg about double the size I think I might need if stocks will comprise a significant portion of my investments after I’m within a decade of my target retirement date.

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  • guest

    OK, for the financially illiterate out here, can you just tell me how much money I need to invest before I retire, assuming I’ll be debt-free (including the house) and plan on living for a good 30 years after I retire? Our financial planner says we should be good with $1M. I don’t believe it. Once the house is paid off we could live off $40,000 easily – and that would include traveling. I’m soooooooooooo confused.

    • None of us knows the return your nest egg investments will earn while you’re in retirement, so that’s the tough part of forecasting.

      But if you can live off $40k in retirement, and IF your retirement funds earned a real rate of return of, say, 3% annually on average (that means 3 percentage points more than the rate of inflation), then you’d need about a $795,000 nest egg to start for it to last 30 years. This is just mathematics. If you managed a 5% real return on your nest egg investments, you’d need about $630,000 to start.

      If you’re drawing Social Security of say $15,000 a year and so need to withdraw only $25,000 annually from your nest egg, you’d need about $500,000 to start if you earned 3% on your nest egg investments or ‘only’ about $395,000 if you earned a 5% real rate of return.

      Given the uncertainty of all sort of things over your 30 years of retirement, your planner may simply be recommending a substantial cushion. How much cushion you’re comfortable with is up to you.

      • annonymous

        Wow! Maybe our financial planner wasn’t so far off the mark. I figured we’d need a good $2M to retire on, even living frugally, given the cost of assisted living and nursing care homes. Hmm…. Thanks for your input.

  • Herbert

    I find financial planning for retirement really challenging. It’s difficult to estimate future inflation rate and factor it in for your calculations. I’m following the conventional way of a diversified portfolio with a bit of everything – shares, bonds and bullions. Maybe will look into my asset mix once again when I’m more literate about such matters….

  • Travis Pizel

    When I meet with my financial advisor, we always go with the “what do you need to retire and continue to live the lifestyle you are now?” Obviously we assume for some different living conditions (like the house paid off). But using that question is exactly why one should meet frequently and re-evaluate their goals….because as you move through life, the lifestyle you live “now” changes!

    • Very true! And I think a lot of folks consciously or subconsciously think they’ll live cheaper in retirement, but when that day comes, cutting back on expenses may not be so easy or desirable. We live modestly now, and I think I’d want to continue our lifestyle as it is in retirement.

  • That’s why I believe dividend investing is a better choice investing for retirement than the 4% rule. If the companies pay dividends and continue so, you don’t have to worry about your principal that much. Even if the companies crash, the solid dividend growth stocks tend to keep their dividends intact (just see the recent 2008 crash, of course there are a few exceptions), so your income is still flowing in.

    • That’s what I thought when I made a substantial investment in GE. Then, after 100 years of dividend payments and 32 consecutive years of dividend increases, GE cut its dividend by 68% in 2009. Ugh.

      • Kurt, of course it happens, but if you own 30 or more dividend paying stocks, one dividend cut won’t hurt you. If it was the only stock you had, than the loss can be substantial. Also you can see when the cut is imminent and sell before a huge damage is done.

  • Very helpful charts, calculations, and warnings about market volatility. While I feel comfortable assuming it will even out over the long haul, it also makes sense to plan for the possibility of the market taking a dip in the early years of retirement, and how to avoid that having a big impact on the nest egg.

    • Thanks for your comment! The challenge of volatility I think is particularly acute for those within, say, 10 years of a hoped for retirement date, or early in retirement. A 50% stock market drop–which has happened twice in the past 15 years–puts incredible pressure on such people. Only the superhuman I think can resist the urge to sell and preserve what remains of their nest egg.

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