How much money do you need to retire? A hundred grand? A half-million? Ten million?
I’m getting ahead of myself. Have you even tried to calculate how much money you’ll need to retire? Chances are you haven’t.
The Employee Benefit Research Institute, based in Washington DC in the United States, reports that 56% of workers haven’t made an effort to figure it out. Maybe that’s why statistics show nearly 75% of retirees haven’t saved enough and say they would save more if they could do it all over again.
How much money do you need, then?
In his book The Number, former Esquire Editor-in-Chief Lee Eisenberg talks about why ‘the number’ is so important. He says that, for most people, it represents a free pass to a great life without financial stress.
That’s what it always meant to me. When I was in my 30s, I had a number in mind. It was a net worth number. I was determined to achieve it in fewer than 10 years. And I did. But after retiring, I quickly discovered I was using the wrong number.
Net worth matters, but it is not ‘the number’ you need to plan your retirement. Your net worth includes all assets — including your house and your favourite ‘toys’ — which you may not be willing to give up in retirement. That’s what happened to me. I wasn’t psychologically able to move into a smaller house, get rid of my little fleet of vintage cars, desist from buying fine art, etc. It was a big lesson.
‘The Number’ is how much you need to replace your active income and pay for your expenses…after you’ve quit your 9-5 job.
Because I used the wrong number, I had to go back to work. I picked a new number, a real number, and worked another 10 years to hit it. When that day arrived, I felt fantastic.
I also changed my priorities. Making money was no longer my No. 1 goal. I could spend more time on hobbies — some of which were businesses (such as my art gallery and my film production company) that had little chance of making serious money.
This is a good feeling, one I can recommend to you. If you haven’t had that feeling yet, I hope that what I’m about to tell you will put you on the right track…
Most people fail to achieve their retirement dreams, Eisenberg says, because they make two mistakes:
Many people enter their 40s and 50s ‘ensconced in a cloud of avoidance and denial about the years ahead of them’. They spend their early years not doing any serious retirement planning. ‘They sense they are far behind from where they should be, but they don’t want to face the truth. These are the procrastinators,’ Eisenberg says.
Other people do retirement planning, but they’re sloppy about it. They don’t know how to calculate their ‘number’ correctly, so they pick arbitrary numbers and hope for the best. Eisenberg calls these people ‘pluckers’ because they pluck numbers out of nowhere.
You don’t have to make these mistakes. They are actually easy to avoid. Let’s do that now. Let’s figure out how much money you have to save in order to quit work and enjoy retirement fully. I call this your ‘Magic Number’.
Five Steps to Finding Your Magic Number
I am going to give you five calculations. Each one should take just a few minutes. The entire process, including all five steps, should take no more than half an hour.
Please do it now. In terms of your future wealth and happiness, it may be the most fruitful 30 minutes you ever spend.
Step 1 – Calculate How Much Money Your Current Lifestyle Requires
The first step is to calculate your Lifestyle Burn Rate (LBR). This is the amount of money needed each year to enjoy your lifestyle.
It’s easy to determine this number. Simply calculate how much you are currently spending to live life each year.
I find it helps to group the expenses into five categories: housing (including maintenance and taxes), basic living expenses (food, clothing, healthcare, etc.), education (if applicable), entertainment (including travel), and charity (if you believe in it).
This exercise may be illuminating. (When I re-did it recently, I was shocked to find how much money I’m spending on cigars —$14,000!) You may find this exercise alters your idea of a quality life (I’m cutting back to one stogie per day).
It will also make it easier to make adjustments in the future, if your lifestyle changes
Don’t guess at these numbers. Guessing, in my experience, correlates with grossly underestimating. Use your actual costs from the past year.
Your LBR is a critical number. Without it, you can’t make any other financial planning calculations — such as how much money you need to save for retirement.
Your Lifestyle Burn Rate (LBR) is likely to change three times.
The first stage is up until you have your first child. The second stage begins when you have your first child and continues until your children are gone and their education expenses (if you are paying them) taken care of. The third stage begins after you are free and clear of dependencies, and it continues until you pass away.
For most people, the first stage has the lowest lifestyle burn rate. You are young and relatively unburdened. If you are wise, you will limit your expenses to necessities and drink cheap wine.
The second stage, typically, has the highest lifestyle burn rate. You have larger home expenses, bigger basic living and entertainment expenses, and educational expenses for your children. For some people, this stage extends in time if you’re required to provide for aging family members.
The third stage has a LBR that will likely be twice that of the first stage, but significantly less than the second stage. This is — or can be — a wonderful part of your life during which you can enjoy travelling, hobbies, and entertainment without working more than you want to.
To complete this exercise, you’ll need to calculate your LBR for your current stage and for stages you haven’t completed. If you are in stage one, you’ll need to figure out your current LBR and estimate it for the second and third stages as well.
Step 2 – Adjust Your LBR to Account for Any Changes in Spending Patterns That Will Be a Part of Your Retirement Lifestyle
The next step is the one most people start with: deciding how much money you’ll be spending each year in your retirement to enjoy the lifestyle you want.
I just told you how to calculate your Lifestyle Burn Rate (LBR). What you are doing now is figuring out your Retirement Lifestyle Burn Rate (RLBR).
Take your current LBR, the one you just figured out. Now add to it any ‘extras’ you want to enjoy during retirement and remove any expenses you won’t have in retirement.
Let’s say, for example, that your current lifestyle burn rate is $80,000 per year. To make your retirement more fun, you want to own an extra car — a sports car — and join a golf club. This will cost you an extra $10,000 per year. Add $10,000 to the $80,000 and you have $90,000.
Or maybe you plan to travel Europe. Or you want to help finance a grandchild’s education. Regardless of what it is, here’s where you add in those anticipated costs.
Now subtract from that total number (in this example, $90,000) any expenses that you currently have but will no longer have when you are retired. This commonly includes expenses for your children and other expenses related to having a family with children.
For example, if those expenses are currently $15,000, you will deduct that $15,000 from the $90,000. That would leave you with $75,000.
Step 3 – Adjust Your RLBR to Account for Any Additional Sources of Income
The next step is to take your RLBR and subtract from it any income you are confident you’ll receive during your retirement. This income could include social welfare payments, a company pension, or side-business income.
For example, if you trust that the Age Pension will still be around when you retire, you can find out what your projected yearly welfare income will be.
Slash that by 50% and subtract that from your RLBR.
You can do the same with any pension income you expect. And finally, if you intend to work part-time during retirement, you can deduct that too.
Let’s get back to the example. Let’s say you just calculated your RLBR and found you’ll need $75,000 per year. To make these new calculations, you would deduct, say, $15,000 per year that you expect to get from the Age Pension.
Then you’d deduct another $5,000 per year you expect to get from your super. And finally, you’d knock off another $5,000 per year you expect to get by working as a golf ranger two days per week.
This reduces your RLBR from $75,000 to $50,000.
This is your Net Retirement Lifestyle Burn Rate (NRLBR). It’s an important number.
Step 4 – Determine What Rate of Return You Expect to Get on Your Savings
You’ve just gone through the steps to calculate your NRLBR. In our example, that amounts to $50,000 per year. This is the amount needed to live the retirement you want.
There’s one last thing we must know before figuring out your Magic Number. It’s the rate of return you can expect to get on your retirement savings.
For instance, if you expect to get only 5% on your money, then your Magic Number — the amount you’d need to save before retiring — would be $1 million ($1 million generates $50,000 per year at 5%).
If you could get 10% on your retirement funds, you could retire much sooner…since you’d need only $500,000 at 10% to generate $50,000 in annual income.
So what rate of return should you plug into this equation?
That depends on what kind of investments you use. Most financial planners will spread your money into an assortment of stocks, bonds, and cash.
But I don’t like the idea of having my retirement fund in just stocks and bonds because the market can fluctuate greatly from year to year.
A better choice would be to follow the right asset allocation model, which includes seven different asset classes. Asset allocation is the process of dividing one’s wealth into different asset types such as stocks, bonds, real estate, gold, and cash. I recommend rental real estate, stocks, bonds, gold, cash, and income.
Let’s say you own investments in only three classes: stocks, rental real estate, and bonds. And let’s say you weighted your investments equally in each class. It would be reasonable to expect the following returns on those asset classes (after taxes):
Rental Real Estate: 12%
Since you have equal amounts invested in each asset class, that means your total expected after-tax rate of return would be 8% (the average of all three asset classes).
You now know how much money you need to earn annually to enjoy your retirement. And you know the rate of return expected from your lump sum of allocated investments. That means you have the tools to calculate your Magic Number.
Step 5 – Calculate Your Magic Number
To figure out your Magic Number, start with your NRLBR. In our running example, that was $50,000.
Now, divide it by the expected rate of return you just calculated.
Using the same example, you would divide the $50,000 (NRLBR) by the expected rate of return, 8%. Fifty thousand dollars divided by 8% (0.08) is $625,000.
That is your Magic Number! If you had this amount of money invested right now making 8% each year, you could retire.
If your net RLBR were $100,000, your magic number would be $1.25 million. If your net RLBR were $300,000, your magic number would be $3.75 million.
Get it? Just divide the income you will need in retirement by your after-tax expected interest rate.
In case you are lost, let me break it down for you again, using the original example. The following is just an approximation…
Check your bank ledger and credit card statements and figure out how much you spend each year (this is your LBR). In our example, this is $80,000.
Adjust your LBR for how much money you’ll need to spend during retirement to provide the type of lifestyle you want (this is your RLBR). This gives you $75,000.
Adjust your RLBR lower to account for any income you expect to receive during retirement. This gives you an NRLBR of $50,000.
Determine the after-tax rate of return of all your investments combined that you can expect to receive on the money you have invested. In our example, that is 8%.
Calculate your Magic Number by dividing your NRLBR by your rate of return. $50,000 divided by 0.08 = $625,000.
Congratulations. You just figured out exactly how much money you need in order to retire. Write it down on a sticky note. Put it on your office desk or file cabinet. Always keep this number. The magic number you need to hit.
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