What’s Your Number?

Today I want to talk just briefly about how much money you’ll need to be financially secure. Now, this number varies for each person.  And I know that there are numerous ways that you can come up with the amount you’ll need to retire or be financially free, but I prefer to keep it very simple.

Here’s how I think about the amount of money I’ll need to be financially free. I think about my current level of income and then ask myself: Could I live on that income for the rest my life?  I also ask myself: Is that the standard of living that I want to have going forward? If the answer is yes to these two questions, then my current level of income is my starting point.

I take my current level of annual income and then divide it by 4%. So, for example if I need $40,000 in annual income to live the way I want to live in retirement, then I would need to have investment funds equal to at least $1 million.

The reasoning for this is pretty simple. If I have $1 million of investment funds, and I assume that these funds can grow at an annualized rate of 7% (probably a fairly conservative assumption going forward), then I can take out 4% each year for my living expenses and keep the other 3% in the investment account.

That would mean that if I have $1 million in my investment account, over the next year, I should be able to pull out $40,000 for my living expenses, and keep the remaining $30,000 in earnings in the investment account.  If I did this, at the end of the year, my investment account would have approximately $1.03 million in it.

If we assume that inflation is going to continually be around 3% per year going forward (and that’s about the level that it has been historically in the United States), then having $1.03 million in an investment account after one year should provide the same standard of living as having $1 million in an investment account today.  Thus, by keeping the remaining 3% of annual earnings in the investment account and not withdrawing the full amount of earnings for the year, you’ll keep your purchasing power constant.

This means that if you earn the same 7% in year two, and you only pull out 4% for living expenses, you’ll end up pulling out $41,200 in year two.  This $41,200 in year two should provide approximately the same standard of living as $40,000 in income this year (year one).

So, by leaving the extra 3% in your investment account, you’re planning for future inflation to run about 3% per year.

And just so we’re on the same page, inflation (as I think about it) is how much goods and services in aggregate increase in price each year. Put another way, it’s how much extra money you’ll need to spend next year in order to maintain the standard of living that you had this year.  (Perhaps some economists would disagree with the way that I phrased that, but that’s the way I think about it.)

So, given this simple formula, we can figure out what our number is right now (that is, how much we would need in investment assets to retire or be financially free right now):

Our # Today = Annual Income / 4%

As an example, if you needed $70,000 per year for living expenses, you would need to have investment assets equal to $1.75 million in order to retire today ($70,000/0.04 = $1,750,000 = $1.75 million).

Okay, that’s fine if we’re going to retire today.  But what if we’re not planning to retire for another 10 years?  Well, if that’s the case, we would need more money to retire on in the future. If you do the math and assume 3% inflation for the next 10 years, then you would need about 35% more in 10 years to retire ((1.03^10)-1 = 0.3439 = approx. 35%).  Using our original example (in which our annual income was $40,000 and our number today was $1 million), it would take about $1.35 million to retire in 10 years.  This level of investment in 10 years would provide you with about $54,000 per year for living expenses, assuming the same 4% withdrawal rate.  (Again, $54,000 in income 10 years from now should provide you with approximately the same standard of living as $40,000 today.)

So that’s the really quick and dirty way of coming up with your number – i.e., the amount of money that you would need to have invested in income producing assets to retire.

Obviously, there are a number of other things to consider before retiring (health care costs, taxes, life insurance, estate planning, etc.), but I think my simple formula above provides a good starting point.

A couple of parting thoughts….

• If you’re able to invest at a rate of return above 7%, then you may not need as much money to retire on. However if that’s your plan, you need to be very sure that you can actually hit that higher rate of return year after year.
• For me to consider myself financially free, I think I would also need to have a six-month cash reserve (in case of emergencies) and own my home and cars outright.  I’m a pretty conservative guy.