None of us knows how long we will live. But you can be sure that the longer you live the more money you will need. According to IRS issued life expectancy tables, the life expectancy for a 25 year old is 83.2, for a 50 year old 84.2 and for a 75 year old it’s 88.4.
The older you get the more years you are expected to live. We can thank medical science and our healthier lifestyles for this increased longevity. In 1900, the average life expectancy was 47 years old!
Some of you reading this may be so far away from retirement that you don’t think about it. You’re more concerned with building your career and allocating your money to buy and do the things you want now. Others are realizing that it’s time to get serious about having a plan. Then there are those near retirement or in retirement and know that the nest-egg has to last.
The bottom line is: once you stop earning income you will start withdrawing from your savings to support your lifestyle. For most people, these savings plus social security (and maybe a pension) will be your new “salary.” If you retire at age 65, your savings will need to last for 20-30 years or more.
How can you estimate that you will have enough?
Fortunately, a lot of research has gone into determining how much a person can withdraw each year from their savings and still have enough to last to their life expectancy. A widely accepted solution is the 4% withdrawal rate formula. This is how you calculate it: Total value of savings at retirement x 4% = your first year withdrawal amount. Each year thereafter increase this amount by the rate of inflation (assume 3%).
The 4% Withdrawal Rate Formula Illustrated:
Nancy (hypothetical example)
Nancy is 65 and about to retire. She has saved $2,000,000 that she has invested in a balanced portfolio of stocks and bonds appropriate for her age and risk tolerance. 4% of $2,000,000 is $80,000 – under the 4% rule, this is the amount that Nancy can withdraw from her nest-egg in the first year to start her withdrawal program. She also is entitled to $21,600 in Social Security benefits.
To protect against spending down her savings too quickly, Nancy will need to budget to spend around $101,600 a year. In each year thereafter, Nancy can increase this amount by the rate of inflation (let’s assume 3%), so in the 2nd year she can withdraw $82,400 and in the third year $84,872 and so on. (Social Security income adjusts for inflation as well). If in a particular year her investments go down more than expected due to market conditions she may need to make adjustments in the amount she withdraws. If Nancy’s pre-retirement life-style cost more than $101,600, she will be faced with figuring out ways to cut back.
A word of caution: predicting future investment returns and inflation rates is near impossible. In addition, each person’s financial situation will be different. But a better understanding of what you will need to save and invest now is critical for your financial future.
Remember: A longer life means savings and investing now for a comfortable retirement.