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How Much Money Do I Need to Retire? (In 2 Easy Steps)

People ask this question all the time. And, in my experience, most people assume that answering the question will involve a lengthy process of complicated calculations.

It doesn’t. It’s actually quite easy:

  • Step 1: Determine how much income you will need from your investments each year. (There’s no way around this step. If you skip it, you’re just guessing.)
  • Step 2: Find out how much it costs to buy an inflation-indexed single premium immediate fixed annuity that will guarantee you that much income for the rest of your life.

That’s it. Nothing tricky about it really.

That said, it’s worth making a few related observations.

First, you cannot safely retire on less money. Reason being that with an annuity, you get a payout that is higher than could safely be taken from a typical portfolio of stocks/bonds/mutual funds. (In exchange, you give up the possibility of leaving the money to your heirs.)

Second, if you want to leave something to your heirs, you need more. (Naturally, how much more you’ll need depends on how much you want to leave behind.)

Third, the more money you have in comparison to your necessary investment income–that is, the lower your necessary withdrawal rate–the less of your portfolio you’ll need to annuitize. If your necessary withdrawal rate is low enough, you may not need to annuitize at all, as you’ll be able to get away with a typical stock/bond portfolio.

And finally, when it comes time to actually buy that annuity, you’ll want to a) look for insurance companies with strong financial ratings, and b) do your best to stay under the limit backed by your state’s guarantee association.

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Comments

  1. You seem to be moving more and more towards recommending annuities. That said, a few questions:

    - Step 1: I assume you mean pre-tax income, correct? Where do SS and pensions fit in?

    - Step 2: Are there ways to shop around for annuities to get the best quotes? Have you done any sleuthing on which companies provide the most favorable terms? Do you believe in laddering annuities or buying just one?

    Also: If more and more people living longer and longer buy annuities in the future, will this be a disincentive for insurance companies to provide them on favorable terms to consumers?

    Thanks.

  2. I think you make a great point: If you want it simple, and guaranteed, consider an annuity done right. Of course the key is “done right”…

  3. “You seem to be moving more and more towards recommending annuities.”

    Really I’m just writing about them more often. For the first year or so of this blog’s life, I focused primarily on the accumulation stage–probably just because that’s the stage I’m in, so it’s what I thought most about.

    Now, for whatever reason, I find my interest drawn toward the distribution stage. And as a result, annuities come up a lot more. (And yes, I do recommend them as at least a part of the portfolio for most retirees, given that most people tend to under-save.)

    “Where do SS and pensions fit in?”
    Step 1 is to calculate income necessary from investments. SS and pensions directly reduce this amount.

    “I assume you mean pre-tax income, correct?
    Given the way annuities are taxed (as well as the fact that they can be purchased with tax-free money), it’s slightly more complicated than that.

    I probably should have written in step 1, “Determine how much after tax income you will need from your investments.” Then step 2 should be “Find out how much it costs to buy an inflation-indexed single premium immediate fixed annuity that will guarantee you that much after tax income for the rest of your life.”

    “Are there ways to shop around for annuities to get the best quotes?”
    Good question. I don’t have any insights here. Perhaps another reader can chime in with some good info?

    “Do you believe in laddering annuities or buying just one?”
    As to buying just one, I’d first caution to stay under the state-backed limit regardless of how you decide to time your purchase(s).

    As to when to buy, my approach would be that outlined in this post. Once you don’t think you can safely beat the return that you’d earn by delaying the annuity purchase, I’d go ahead and buy as much as you plan to.

    “If more and more people living longer and longer buy annuities in the future, will this be a disincentive for insurance companies to provide them on favorable terms to consumers?”

    As life expectancies increase, yes, payouts must decrease. That said, I do not think that more people buying annuities would lead to a decrease in payouts.

  4. Three points:
    1. I assume you are talking about an annuity with a COLA.

    2. Timing is important in this. I believe sometime within the next 5 years you will look back and be amazed that you recommended annuities at the low rates prevailing today, i.e. with short term rates practically zero.

    3. People need to understand that when you buy an annuity you lose control of the money. Cars breakdown, kids and/or parents need help, you decide for medical reasons you better do more traveling in your earlier retirement years than you figured , guess what? You can’t get the money without paying a huge penalty.

  5. “I assume you are talking about an annuity with a COLA.”

    Yes, I said “inflation-indexed single premium immediate annuity.”

    “I believe sometime within the next 5 years you will look back and be amazed that you recommended annuities at the low rates prevailing today.”

    I’m not recommending buying an annuity today. I’m suggesting using annuities as a starting point for calculating how much you’ll need to retire. For my thoughts on when to actually buy the annuity, see this post.

    “People need to understand that when you buy an annuity you lose control of the money.”

    Agreed. If you annuitize your portfolio, then later decide that the amount you calculated in step 1 was too low, you’re up a creek.

  6. Hi,
    I found this article and read the comments, and thought I’d lend a hand.

    >> I assume you are talking about an annuity with a COLA.<>Timing is important in this. I believe sometime within the next 5 years you will look back and be amazed that you recommended annuities at the low rates prevailing today, i.e. with short term rates practically zero.<>People need to understand that when you buy an annuity you lose control of the money.<<

    That's not always the case. There are annuities that allow you to get to your money anytime you want, even in payout mode. They're relatively new, so most folks haven't heard about them.

    You may or may not pay a small charge for taking that extra amount, but it's not very much in any case. It's nothing like having to take money out of a stock account that's down 20%. And certainly if you have bonds and you need money, you need to cash in… a very expensive thing to do if interest rates have risen much since you bought it.

    The fact is, for income, there's really no safe way to beat annuities, as long as the planning is done right. Another key is, you should ALWAYS leave some money liquid in case of emergencies, cars, fun, etc. Never tie up all of your money in anything.

    Hope that helps,

    Marc

  7. All the annuities I’ve seen ( that I’ve been able to understand after reading the small print etc.) charge for getting funds back for up to 7 years. This is understandable because they are a middleman investing your premiums in longer term bonds ( actually in bonds that have an average duration equal to your life expectancy) and they face the possibility of an increase in rates causing the bond prices to drop.

    How about this – you give me $100,000 and I’ll give you a certain paycheck monthly for the rest of your life. Suppose you need to take $20,000 at the end of the year for an emergency and I charge you 7%. Is that a lot?

  8. Given those facts, you’d pay 7% of $20,000, and that’s $1400. The thing to understand is that all investments have upsides and downsides. Regarding this case, consider these things:

    1) It would have been better to have had that $20,000 liquid from day one, and not tie it up in a long-term contract. That’s what emergency funds are for.

    2) If you had to pull that $20,000 out of a fund that was down 20%, you’d have lost $4,000 in the deal… much more than $1400. Not only that, but now ALL of your money will be down 20%. And every monthly payment you take from that fund will be made with money that is now down 20%. That’s a way to go broke really fast.

    3) If you’d had that $100,000 in the bank earning only 1% or 2%, you’d be paying a very high price for an event that might never happen. Getting 6% on that $100,000 would give you $6,000 per year, as opposed to the $2,000 you’d get from a 2% savings account. That’s a cost of $4,000 a year to avoid a POSSIBLE $1400 cost on some future emergency that may or may not happen. Doesn’t make sense to me, but everyone is different.

    No financial product is perfect, and no financial decision should be made in a vacuum because no one can predict the future. We all have to make choices we feel are best for us. A good planner can be very helpful in thinking through all the possible ramifications of our decisions.

    My point here is not to try to get anyone to buy an annuity. I’m just trying to present some information that may help somebody someday.

    And, as long as I’m at it, annuities with COLAs are not the best way to go, IMHO. They pay out a lot less in the beginning, and it can take many years to make up what you’d lose due to the reduced beginning payout. There are better ways to handle the inflation risk.

    Marc

  9. Mike, the comment above:

    “Given the way annuities are taxed (as well as the fact that they can be purchased with tax-free money), it’s slightly more complicated than that.”

    This has me curious about what would happend if I purchased an SPIA with ROTH funds at retirement. Does that mean my premiums from the annuity would not, or may not be taxed?

    I am guessing the answer is probably complicated and I would think at minimum Uncle Sam would at least want to tax the amount of the premium considered earnings (or interest) on the annuity. But then, would this be income tax, or capital gains tax.

    Have you covered this topic already in a previous post?

  10. Firstly, just to make sure we’re on the same page: the premium is what you pay to buy the annuity, not what you get as payment once you own the annuity.

    To answer your question though, as long as you meet the normal requirements for tax-free withdrawals from a Roth (see here), the payout from an annuity purchased inside a Roth will be tax-free.

  11. I wasn’t even thinking in terms of ‘purchasing that annuity inside a Roth account’. That makes sense though.

    For some reason I was thinking in terms of cashing out a Roth IRA to then purchase the annuity with a lump sum.

    Thanks Mike!

  12. I think your two steps are a nice, simple way to get “your number”. The problem is that it still leaves you with the question: “How much should I be saving each year so I’ll reach my retirement goal?”

    There’s no perfect or simple answer to that question. It’s one that needs to be revisited periodically to reflect changes in your situation. It’s also best answered using a Monte Carlo simulation rather than assuming a flat return during your accumulation phase.

    What would you recommend people do to get the answer to this question?

  13. Good question. For those who are a long way off from retirement, it’s tough to answer precisely at all.

    My own method for trying to estimate long-term returns is to use the Gordon Equation (dividends + earnings growth). And to use current yield minus expected default rate for the expected return on the bond portion of my portfolio.

    Then just plan on investing a bit more than those estimates would indicate is necessary. Then redo the calculation every couple years.

    It’s obviously a very back-of-the-napkin sort of route, but I’ve yet to be convinced any alternative is better. (I’m open to hearing other suggestions though…)

  14. That sounds reasonable to me. The key is to redo the calculation every few years like you said. This is an attempt to predict the future, so you’re guaranteed to get it wrong to some degree. By continually recalculating the mark, you increase your chances of successfully reaching your goal at retirement age.

    I spent a bit of time working on a simplified retirement savings calculator a while back and updated it to make it more accurate a couple months ago. I’d be interested in hearing how your calculation compares to the results from my calculator. It can be found here:

    http://www.providentplan.com/465/how-much-should-i-save-for-retirement-part-3-how-much-should-i-save-each-year-free-retirement-calculator/

    Feel free to delete the link after you check it out. I’m not trying to promote it. I just like to bounce this stuff off of you. Thanks, Mike!

  15. For me, your calculator says my wife and I need to save $9,975 per year. My own calculations said $5,667.

    I’m assuming the primary difference is that my figure is based on the assumption that the entire portfolio is annuitized, so the effective withdrawal rate is probably higher than that used in your calculator.

    If I switch my calculation to use a 4% withdrawal rate, the amount becomes $8,477–at least in the same ballpark as the figure from your calculator.

    On an unrelated note, the life expectancy calculator that your post links to predicts that my wife and I will live to be 95 and 89, respectively. Wow!

  16. Anthony says:

    Mike:

    I went to the Vanguard SPIFA calculator linked to in your earlier article, but I can’t get the calculator to work for me–it tells me to call Vanguard. I think the question that’s confusing me is:

    Amount you want to commit
    You may wish to create an income stream that covers the gap between your fixed expenses and your guaranteed income from other sources, such as Social Security or an employer-sponsored pension plan.
    Enter one of the following:
    Lump sum you want to commit $
    – OR –
    Modal income payment you want to receive $

    What’s the proper input here (I assume for the modal income payment)?

  17. In the context I’m using it above, yes, you’d fill in the “modal income payment you want to receive” field. Then later you fill in the frequency with which you want to receive payments. So if you need, say, $48,000 per year, you could enter $4,000 then choose monthly. Or $12,000 and choose quarterly.

    The end result is that they’ll tell you what the premium would be to purchase such an annuity.

    I’m not sure why it wouldn’t give you an answer. (Perhaps some combination of your inputs plus the state you’re in makes it such that they wouldn’t provide an annuity meeting those exact criteria?)

  18. Hmm, the annuitization is definitely a big difference. I think the rest is most likely attributable to my calculator including volatility (the chance you might not reach your goal). However, the data that’s working behind the scenes in my calc is based on Monte Carlo simulations and they’re far from perfect.

    I think the two calculations would converge as you continue to revisit them every few years. I don’t have an easy way to change it to plan on annuitization (too many factors involved there).

    The life expectancy calculator can give some interesting results, but I wouldn’t be surprised if you live that long given your young age. It’s still just an average that’s been tweaked based on your responses to the questions, so it’s not going to be completely accurate. Should be close though. LeChayim!

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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