Whether you're maxing out your 401(k) plan contributions or have hardly begun to think about retirement savings, it's a good idea to have a sense of how much you'll actually need once you hit your golden years. Since the average retiree will draw just $17,532 next year in Social Security benefits, most people retiring today will likely need to tap their savings or keep working to make ends meet.
A time-tested method of calculating whether your retirement savings are sufficient is known as the 4% rule. Back in the '90s, a financial advisor found that if you withdraw 4% of your savings during each year of retirement, adjusting for inflation each year, then there's almost no chance you'll exhaust your savings.
A benchmark for retirement savings
On the positive side, the 4% rule provides a valuable estimate of how much income your retirement savings will yield each year. If you've saved $250,000, for example, then the 4% rule says you can safely withdraw roughly $10,000 per year in retirement. If you receive the average Social Security benefit, you'll get $27,532 in total.
Because the 4% rule can (in theory) tell you how much money you can withdraw each year, it can also help you determine whether your savings are sufficient. If you calculate, for example, that you need $60,000 annually to be comfortable in retirement and will get $17,500 from Social Security and $10,000 from your savings, then you'll be $32,500 short. That means you'll need to boost your savings and/or reduce your costs. That could mean working and saving longer or moving to a smaller home in a more affordable area, for instance.
Young people can harness the 4% rule to forecast how much they'll need for a comfortable retirement. If you're 25, for example, and calculate that you want $60,000 yearly in retirement, you can aim for the savings the 4% rule indicates you'll need. The rule of thumb here is that you multiply the desired yearly income by 25.
Bear in mind, though, that if you want the purchasing power $60,000 currently provides, you'll need to factor inflation into your savings calculations. Over the past century, inflation has averaged 3.22% annually, although it varies a great deal from year to year. It's a good idea to use an inflation calculator like this one to see how much of your income will be replaced at retirement.
Further, when you're thinking about inflation, keep in mind that, although Social Security benefits receive periodic cost-of-living adjustments, those don't entirely keep up with inflation. That's partly because the measures used don't reflect retirees' disproportionately high healthcare costs. Forecasting increases in Social Security benefits is tough, frankly, because a systemwide Social Security benefit adjustment going forward can't be ruled out. But it's prudent to make your inflation estimates on the high side of the 100-year average because of the lag.
Ultimately, for that $60,000 per year in retirement, you'll likely need a bit more than $1 million in retirement savings in today's dollars.
Assumptions behind the 4% rule
But it's important to remember that the 4% rule is a benchmark, not an infallible law. The 4% rule was devised 24 years ago as a method to let retirees know how much they could withdraw every year without running out of money. It used some very specific assumptions. Our times -- and your situation -- could be very different from those bedrock assumptions. If they are, you'll need to factor different scenarios into your 4% rule calculations.
1. It assumes a portfolio split 60%/40% between stocks and bonds
The 4% rule assumes 60% of your portfolio is in stocks, while 40% is in bonds. Your own portfolio -- depending on your age, goals, and risk tolerance -- may have a different allocation. A good rule of thumb is to subtract your age from the number 110 to determine what percentage of your portfolio to place in stocks. The remainder should be in fixed-income investments, such as bonds. So a 25-year-old would keep 85% of a retirement portfolio in equities, while a 75-year-old would keep just 35% in them.
The reason this handy rule works? Over time, stocks have returned on average substantially more than any other asset class, so they can power a retirement portfolio's returns over the decades. But stocks also fluctuate. Down years in the stock market can hurt a portfolio. A younger person will likely have time to regain losses, but a retiree should manage risk by having proportionately more invested in less volatile investment classes -- while still being able to partake in potential stock market upside.
One caveat here, though. You also need to factor in your own risk tolerance. Yes, stocks have historically performed well over time. But if the idea of a bear market keeps you up at night, you need to adjust your portfolio to reflect your risk tolerance, and get some sleep. A risk tolerance quiz can be found here.
Keep in mind, however, that if you have a portfolio more heavily invested in bonds, the 4% rule may need to be adjusted. You may need to withdraw less than 4%. If you're more aggressively invested in stocks, you could withdraw more, although you will also want to factor in the potential effects of market volatility on aggressive investments.
2. It makes specific bond yield assumptions
The 4% rule was developed with bond yields of the 1990s in mind. For the past decade, bond yields have been about half what they were in the mid-1990s. If you purchased bonds with very low interest rates, you may have to ratchet down the 4% assumption accordingly.
Interest rates have been on an upward climb since late 2015, which means bond yields will rise as well. Remember, though, that when yields rise, bond prices go down. So factor in both the prices and yields in your portfolio when tailoring your assumptions.
3. It is set up to make funds last 30 years
The 4% rule is designed to ensure that your retirement funds last 30 years. But frankly, you may not need your savings to last that long. An increasing number of Americans are working into retirement age. If you plan to work until 70, for example, you may not need to tap your nest egg for 30 years. In addition, only about 10% of the U.S. population lives to the age of 95. While it's important to ensure that your retirement funds last, you may also want to make prudent estimates of your expected longevity.
If you don't need your nest egg to last 30 years, restricting yourself to 4% may be stinting unnecessarily. It may be possible to withdraw 4.5% or 5%.
The bottom line here? Use the 4% rule as a benchmark to calculate whether you're heading toward enough savings for a comfortable retirement. But factor in the scenarios that fit your specific situation as well.
The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.