“How much do I need to retire?” is a question that comes up over and over again. So once and for all, let me suggest a simple, very logical and conservative way to figure out how much you will need.
THE BASIC FORMULAS:
Average Annual Gross Income of Your Lifetime / Risk-Free Rate of Return = Retirement Goal
In other words, let’s say you make $100,000 a year on average in your 40-year career. All you need to do is find out the risk-free rate of return (look up the latest 5 or 7 yr CD and 10-year yield and average the two), and divide $100,000 by that figure. Since the 10-year yield and 5-7yr CD is roughly around 2.5% divide $100,000 by 0.025 to get $4,000,000, which is the amount you need to retire on.
Retirement Goal X Risk-Free Rate = Average Annual Gross Income
This is the same equation, just rearranged. If your retirement goal is $2,500,000 and it’s sitting in the bank right now, you would earn $62,500 a year for the rest of your life risk-free, if you don’t touch the principle and the interest rate is 2.5%.
Current Salary X The Inverse Of The Risk-Free Rate = Risk-Free Income.
Finally, you can also multiply your current salary, or the realistic salary you think you’d comfortably survive on by 40 (the inverse of the 2.5% risk free rate) to achieve your retirement goal. If I had zero debt, I’d comfortably be able to live on $50,000 a year, based on a $2,000,000 cash nest egg.
INTEREST RATE ENVIRONMENT THOUGHTS
When I first wrote this basic post, the 10-year yield risk-free rate was at 4%. Hence, all one needed was $1,250,000 in cash to generate a $50,000 a year risk-free income. The Fed has telegraphed quite clearly through QE2 that they will do everything in their power to keep interest rates low, to the dismay of savers. So what should you do?
The most obvious thing to do is to not save, but spend! Of course, don’t spend on anything if you are looking to build wealth. Spend your money on real assets, such as commodities, precious metals, real estate, and the Chinese RMB. The medium of exchange, cash, is being devalued, which means the real assets by which the currency is used for will grow in value. Take your time though, as a low-interest rate environment is also a reflection of a low inflationary environment. Sooner or later, inflation will come, but unlikely for at least a couple years. When inflation comes, expect house prices to really start climbing again.
I’m pretty confident that if you follow any of these formulas, you will be set for the rest of your retirement life. The theory is, if you’ve been used to living off $100,000 gross income a year for your entire life, you aren’t suddenly going to want to need more income to survive. Furthermore, when you retire, there may be other benefits such as Social Security and no more debts to pay, which makes $100,000 that much more viable.
MANAGE YOUR MONEY IN ONE PLACE
Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. You can use Personal Capital to help monitor illegal use of your credit cards and other accounts with their tracking software. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely check to see how your financial life is shaping up since it’s free.I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.
Updated for 2016 and beyond.