Retiring and committing yourself to live the rest of your life off of a set sum of money is a scary prospect. As I’ve written before, both of my grandmothers asked “do I have enough money to last me for the rest of my life?”, so this is a source of anxiety for many people even when they’re well INTO retirement! One woman I know worries endlessly about money, constantly trying to cut costs everywhere possible. She said to me once that she’s one step up from putting her money in a mattress. I feel badly for her, as this anxiety clearly diminishes her enjoyment of life. Having an understanding of your finances and what you can expect from them in the future is a massive benefit in your life.
How Much Do I Need?
I’ve written about it before, and likely will write about it again, but you can plan to live off of 4% of your net worth annually. What this means is, take your net worth, multiply it by 0.04. Divide it by 12, and that’s how much you can spend monthly from a lump sum of money with the expectation that it won’t be depleted for longer than 30 years.
For example, say you had a net worth of $500,000. You can spend $20,000 per year (500,000 * 0.04) or $1,666.67 a month (20,000/12).
Looking at this another way, first figure out your monthly expenses. Multiply this by 12 (to get your annual expenses), then divide it by 4% to figure out how much you’d need to cover those expenses indefinitely.
For example, say your expenses were $2,200 per month. To be able to retire and cover this from your investments, you’d need to have a net worth of $660,000 (2,200*12/0.04).
What About Inflation?
A great objection some people might have at this point is that inflation is a concern. Your monthly costs should go up every year, so what do you do with your ever-increasing expenses. With the above calculations, we’re working with real returns. This basically means we’re decreasing our return by the average inflation rate so that we can think about future costs in terms of today’s dollars. Have a look at this post about real versus nominal returns.
What if I’m Not Sure About My Expenses?
It isn’t the simplest thing in the world to just say “my monthly expenses are $X”. Different months have different spending and with a few credit cards, an investment account or two, a checking and savings account it can be hard to figure out what your actual monthly spending is.
Both of the below techniques are simply a measure of what percentage of our paycheck we are saving vs. spending.
One technique I’ve used, which worked great, was to keep a small notebook and a pen in my pocket (obviously this was before the days of smartphones). EVERY time I spent money for any reason or through any method (cash, credit card, online bill payments) I’d write it down. Every few days I’d copy these to a spreadsheet, assign them to a category and calculate my average monthly spending. A smartphone app or You Need a Budget makes this even easier.
Another technique is to look at all the times you transferred cash to an investment or savings account and figure out what the monthly average is based on this (divide the sum of the transfers by the time period they occurred in). Subtract this from your take-home pay and you have (roughly) your monthly expenses.
How Long Will It Take For Me to Get There?
In the previous section, we figured out our monthly expenses. If we divide our savings (just net income – expenses) by our income, we have our savings rate. Another way to think of this is to divide your expenses by your net income to calculate a spending rate, then subtract this from 100 to get your savings rate.
For example, say I earn $3,300 per month (net after taxes, this is what shows up in my checking account via direct deposit). If I figure out my expenses are $2,800 per month, this means I have a spending rate of 85% (2800/3300) or a saving rate of 15% (either 100-85 or (3300-2800)/3300).
The math to then figure out how long until you have enough to retire off of is a LITTLE bit more complicated. You can either look up the value on the chart at this Mr. Money Mustache post, or plug your numbers into this early retirement calculator). In the above example, if we currently had $100,000 net worth, using the early retirement calculator linked to, we can expect to retire in 29.5 years.
What Do I Do With All This?
I get that a post like this can seem like it’s in a foreign language for people not that comfortable with math. I think it’s worth the payoff of thinking through these calculations. If you understand what they mean, it will tell you if you can afford the lifestyle you’re currently living in retirement, it can tell you if you’re on track to retire when you hope to and it can tell you when you could achieve financial independence based on different savings rates.
What is your current savings rate? How long until you’re able to retire off of your savings? Is this before or after your anticipated retirement date?