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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