I’m currently reading Charles Farrell’s book Your Money Ratios. In the book, Farrell suggests that once your retirement savings reach 12-times your annual salary, you should be able to retire. Interestingly, just a few weeks ago, I encountered an article in The New York Times stating that you need 20-times your annual salary in order to be able to retire.
That’s a huge discrepancy! The NYT writer (Teresa Ghilarducci) is suggesting you need 67% more money than Farrell says you need. So who is right?
Neither. (Or maybe both, depending on how you look at it.)
When we talk about retirement planning, there’s always a great deal of uncertainty: investment returns, how long you’ll live, how your tax rate will change over time, etc. But, by basing the how-much-do-I-need number on the reader’s pre-retirement level of income rather than spending, the writers above are adding yet another source of uncertainty and imprecision.
For example, the higher your income level, the greater the portion of your pre-retirement income that you’ll have to satisfy with your portfolio, because Social Security will replace a smaller portion of your pre-retirement income than it would for somebody with a lower earnings history.
Or, if you expect to pay off your mortgage shortly after retiring, you’ll be able to get away with replacing a much lower portion of your pre-retirement income than somebody who plans to rent throughout retirement.
Or, if you started saving very early, such that you’ve been able to use a low savings rate throughout your career, you’ll have to replace a higher portion of your pre-retirement income than somebody who was late to the game but who adjusted to living on just 60% of her pre-retirement income in order to catch up on retirement savings.
When expressed as a multiple of end-of-career salary, the multiple one person needs to reach in order to retire could be twice as high as the multiple another person needs to reach.
Focus on Expenses Rather than Pre-Retirement Income
If you want to get a good idea of how much you need saved in order to retire, it makes more sense to go about it directly — by looking at the expenses you hope to satisfy.
- How much will you be spending per year in retirement, and
- How large a lump sum will it take to finance that spending?
Even when you base your retirement calculations on your actual expenses, there are numerous uncertainties left in the planning. There’s no need to use a rule of thumb that adds yet another layer of potentially-wrong assumptions.