One of the most frequent questions I hear is some variation of this: “How will I know when I have enough to retire?”
The answer is different for every person or household.
You start by gathering some facts. Then you make a few crucial assumptions, decide how much risk you are willing to take, and finally create an action plan based on what you’ve learned.
You don’t need an advanced education to do this, and the numbers don’t have to be precise. In fact, there are enough unknown variables that precise planning isn’t really possible.
In this article, I’ll outline an 11-point exercise that can help you determine whether you are on track to retire when you want to.
Once you complete these steps, your situation should become much clearer — and far less mysterious.
Data point one: Your current cost of living
This is the foundation on which everything else is built. A simple approach is to start with your household income, then subtract payroll taxes and whatever you are saving for the future. What remains is likely what you are spending to support your current lifestyle.
I suggest converting this number to an annual figure.
Data point two: Your assumed rate of inflation
Inflation is a wild card, but it’s a critical one. When I talk with investors, I often use an assumed inflation rate of 3%. That may not sound like much, but over time it can have a significant impact on your financial future.
Data point three: Years until retirement
Retirement isn’t an on-or-off switch, and many people don’t have complete control over when they stop working. Still, this exercise requires a reasonable estimate of how many working years you have left. Do your best to come up with a ballpark number.
Data point four: Your cost of living in retirement
Start with your current cost of living and think through how it might change. You may spend less on commuting, clothing, and retirement savings, but other expenses may increase.
Look at your major spending categories and make reasonable assumptions. Based on my experience, I recommend adding a cushion of 5% to 20%. You and your family will likely appreciate it later.
Data point five: Retirement income you can count on
For most people, this includes Social Security. It may also include pensions, rental income, or notes receivable.
Don’t include investment income yet. That comes later.
Data point six: Income needed from your portfolio
This is simple math. Take your projected retirement cost of living and subtract the income you can count on. The difference is what your investment portfolio will need to provide.
Data point seven: Portfolio size needed at retirement
If your investments are properly diversified, a rough estimate is to multiply the amount from data point six by 25. This assumes a 4% withdrawal rate in the first year of retirement, with future withdrawals adjusted for inflation.
This is only a rule of thumb. Some investors prefer to be more conservative by multiplying by 30 or even 33, which increases the likelihood of meeting retirement goals with less stress.
Data point eight: Current size of your portfolio
Include savings and investments such as stocks, bonds, mutual funds, IRAs, 401(k)s, and cash. Do not include real estate or other illiquid assets.
Data point nine: Annual retirement savings
This is the amount you are adding to your portfolio each year. You already identified it when you calculated your current cost of living.
Data point ten: Your historical investment return
Every serious investor should know this number, but many don’t. If your investments are spread across multiple accounts, you may need help calculating it. A qualified financial professional can assist with this.
Data point eleven: The return you need going forward
Using a financial calculator or spreadsheet, you can determine the annual return required to reach your target portfolio size. You know where you are now, how much you are saving, how long you have, and where you need to be.