You probably need more savings that you think, especially when using the stock market as part of your overall retirement saving plan. Investing in risky assets like stocks, bonds, and commodities exposes you to uncertainty, while planning a successful retirement strategy involves reducing uncertainty to the point where you can sleep at night and still meet your retirement goals.
Let’s start with a common rule of thumb (ROT) that says that an investor should save 20 times her annual living expenses at the point of retirement. In other words, if you have $100,000 per year in living expenses, then you need a nest egg of $2,000,000 in investable capital. Like most ROTs there is considerable variation with single-number projection given the unknowns, such as how your savings are invested, what inflation adjustments are used, market valuation at point of retirement, and other guaranteed income sources. In addition, it is difficult to manage a 5% withdrawal rate ($100,000 / $2,000,000) for 30 years plus cost-of-living adjustments to achieve a low probability of running out money. Moreover, the possibility of living beyond the typical 30-year retirement planning window is no longer a hypothetical.
The Consumption Ratio
Another technique to calculate a first approximation of a sustainable retirement nest egg size is the Consumption Ratio, provided by the good folks at the Retirement Income Industry Association (RIIA). The Consumption Ratio is your annual Consumption (i.e. living expenses) divided by your Financial Capital (which is more or less the market value of your investable assets like IRAs, 401(k)s, savings accounts, individual bonds, etc.)
According to the RIIA, if your Consumption Ratio (Consumption/Financial Capital) is less than 3.5%, then you are overfunded and have bought yourself the flexibility to execute a low risk retirement strategy if desired. If your Consumption Ratio is between 3.5% and 7.0% then you are considered constrained in that you will probably have to either increase the use of annuities (which provide for periodic income payments), save more, or make living adjustments to achieve a low risk, sustainable retirement strategy. Our 20x ROT example would be considered "constrained" at 5% when using the Consumption Ratio framework.
If your Consumption Ratio is greater 7.0%, you are considered underfunded and need additional savings to reduce your dependency on risky investments to make up the shortfall. In many cases increasing your retirement savings investment risk (uncertainty) through heavy stock market participation is unavoidable, but you need to understand the trade-offs.
Finally, please remember to subtract any guaranteed income sources like expected Social Security, fixed annuities, or pension income from your annual Consumption calculation. This will improve your Consumption Ratio by offsetting part of your retirement living expenses.
Get Started with Our Retirement Calculator
In our practice, we like our clients to get "visual." This allows them to see where they are now to determine how much additional savings they need over their target accumulation period to reach an acceptable Financial Capital level that keeps their Consumption Ratio at least moderately constrained, if not overfunded. Thus, we created a simple, interactive retirement calculator that we share with clients and the public to help them determine their target portfolio value (Financial Capital) to keep their Consumption Ratio under 5%. To see how to use the Retirement Calculator, please watch our short help video.
If you are interested experimenting yourself with the Retirement Calculator, you are welcomed to access it via this link: Retirement Calculator.
Please remember that there’s no inflation adjustment on the distribution (drawdown) calculation. In addition, all values are pre-tax even though your target Consumption amount theoretically incorporates an implicit tax expense. Nonetheless, after-tax cash flow is what pays the bills and more detailed tax planning as a next step must be incorporated to a produce more exact retirement savings number. Taxes and inflation will be subjects of future blog posts.
Beware the Flaw of Averages
Rarely in life does an expected investment return match the observed (actual) return. Hence, the longer your planning horizon, the more uncertain the eventual outcome when growth is dependent on volatile assets like stocks. While our Retirement Calculator, along with the Consumption Ratio, will get you started on estimating how much you need to save now, Monte Carlo analysis is required to understand the probability of deviating significantly from your retirement plan assumptions. So, please go forth and start planning by calculating your personal Consumption Ratio.
About Jim Koch Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.
General Disclosures This information is provided for informational/educational purposes only. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. The information contained herein, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable. Past performance is no guarantee of future results. Use of Calculators, Planning Tools, and Other Devices The use of any calculator, tool, or similar device contained within or linked to this website is subject to your acknowledgement and understanding that the projections or other information generated by any such tools is not, and should not be construed, in any manner whatsoever, as the receipt of, or a substitute for, personalized individual advice from Koch Capital, or from any other investment professional. The projections or other information generated by such tools regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, are not guarantees of future results, and may not reflect the actual growth or costs of your own investments. These tools are designed for informational and educational purposes only and should not be considered investment advice. No reliance should be placed on any such information when making an investment decision. Koch Capital makes no warranties of any kind, and disclaims liability to any person for any actions taken or omitted in good faith with respect to such tools. Koch Capital obtains the information provided via these tools from third party sources believed to be reliable but not guaranteed. Koch Capital is not responsible for the consequences of any decisions or actions taken as a result of information provided by such tools and does not warrant or guarantee the accuracy or completeness of the information requested or displayed. Please refer to the Site Disclosure page for additional information. Third Party Information While Koch Capital has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, timeliness, or completeness of third party information presented herein. Any third party trademarks appearing herein are the property of their respective owners. At certain places on this website, live 'links' to other Internet addresses can be accessed. Koch Capital does not endorse, approve, certify, or control the content of such websites, and does not guarantee or assume responsibility for the accuracy or completeness of information located on such websites. Any links to other sites are not intended as referrals or endorsements, but are merely provided for convenience and informational purposes. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness.