Money Toolbox

How Much is Enough?

How can you know when you’ve saved enough? How can you be sure that you’ve saved enough that you can quit your job and pursue your passions for the rest of your life? This lesson answers these questions.

Let’s start by talking about how long you can expect to live.

Life Expectancy

Life expectancy is a key variable in determining how much money you need to save for retirement – and how much you can spend.

If your assumptions about longevity are too pessimistic, you risk running out of money before you die. On the other hand, if your assumptions about life expectancy are too optimistic, you risk not getting to use the money you’ve saved.

Here’s the bottom line: If you knew when you were going to die, you could calculate how much money you’d need to get from now to then.

Unfortunately — or fortunately, depending on your point of view — there isn’t a way to tell with any precision how much longer you have to live. The best you can do is make predictions based on a variety of factors.

Here are three online life expectancy calculators that I’ve tried and liked:

Life-expectancy calculators are great, but the numbers are still just guesses based on population statistics. When you are planning for your own financial future, make adjustments based on what you know of yourself and your family history.

How Much Will You Spend in Retirement?

The 2016 Retirement Confidence Survey found that about 38% of Americans spend more in retirement than they did while working. About 21% spend less. And another 38% spend roughly the same.

Based on this – and other research – I believe that your pre-retirement expenses are an excellent predictor of your post-retirement expenses. So, I use this rule of thumb: When estimating how much you need to save for retirement, assume you’ll spend about the same in the future as you do now. (If you want to play it safe, assume slightly increased spending.)

Having said that, it’s important to modify this general advice based on your own specific situation. Use your current expenses as a starting point when planning for retirement. But make educated adjustments based on your personal goals and expectations.

This projected spending is what’s called your “withdrawal rate”. It’s how much you’ll pull from your accounts to sustain your spending during retirement. From this number, it’s possible to reverse engineer how much you need to save before you stop working.

Sustainable Withdrawal Rates

As you save and invest, you build a nest egg. That nest egg needs to last you the rest of your life.

Let’s say you save $1,000,000 and think you’ll live another 50 years. Based on these guesses, you could do some simple math and estimate that you could take $20,000 from your investments each year without running out of money. This would give you a 2% withdrawal rate ($1,000,000 divided by 50 gives you 2%).

But this oversimplifies things. In reality, you have to take into account inflation, stock market fluctuations, and more. With so many unpredictable variables, calculating a sustainable withdrawal rate — a withdrawal rate that allows your money to last until you dies — becomes very complicated. There’s no way to make a perfect prediction.

One solution is to use historical data to make withdrawal decisions. And, in fact, this is the solution that most folks in the FIRE community have elected to use when figuring out how much to save for retirement.

In early retirement circles, it’s common to talk about the “four-percent safe withdrawal rate”. This concept was first proposed in the October 1994 issue of the Journal of Financial Planning. In an article entitled “Determining Withdrawal Rates Using Historical Data“, William Bengen showed that a retiree with an initial withdrawal rate of 3% – adjusted annually for inflation – would have been (quote) “absolutely safe” based on past inflation and investment data.

That is, a retiree who spent 3% of her portfolio’s value each year would never have run out of money in the past. Her wealth snowball would always have lasted at least fifty years. (The future, of course, isn’t guaranteed to be the same as the past.)

For most people, though, a withdrawal rate of 3% feels restrictive.

Fortunately, Bengen’s calculations showed that a first-year withdrawal rate of 4% – with adjustments for inflation in following years – offered similar results. Based on historical data, a 4% withdrawal rate would have always allowed a client’s wealth snowball to survive for 33 years, and usually much longer.

Because research supports a 4% sustainable withdrawal rate, we can then calculate how big your nest egg ought to be at the start of retirement.

Whichever withdrawal rate you choose, you’ll make adjustments each year to compensate for inflation.

Now, having said all of this, it’s important to note that there are a lot of assumptions that go into these calculations, and changing even a single assumption just slightly produces different results. Use a 4% sustainable withdrawal rate as a starting point. But absolutely make adjustments based on your own risk tolerance, life expectancy, and investment style.

For a much more thorough discussion of safe-withdrawal rates and related topics, check out Karsten Jeske’s safe-withdrawal rate series of articles at Early Retirement Now.

Final Thoughts

Generally speaking, I don’t like retirement calculators. They make faulty assumptions and take shortcuts when making predictions. They’re mostly worthless.

That said, there are a handful of retirement calculators on the web that are useful for FIRE folks. The most popular is probably FIRECalc, which uses the concepts we’ve discussed here to project how much you need to save for retirement. FIRECalc is free and quick to use.

I also like two tools that offer more robust planning: NewRetirement and OnTrajectory. Both of these calculators come in free and paid versions. I’ve found their insights to be very useful for folks pursuing early retirement. (Full disclosure: I am an investor in NewRetirement. That said, I’m not being paid to mention the company here. I just like the product so much that I wanted to be part of its future.)

Additional Resources

Finally, here’s a list of additional resources if you’d like to learn more about the concepts in this lecture.

And don’t forget: If you’d like some general resources for financial independence and early retirement, I’ve created a page here at Money Toolbox that links to useful FIRE apps and tools.

© 2021 J.D. Roth