Let us take saving for retirement for example. The first thing you’d want to know is the amount you’d spend in the first year when you retire. You’d then want to inflation-adjust that amount each year through your retirement.
You’d then want to know how long will retirement last. A 100-year life expectancy is what I’d assume but you can adjust that number to your liking.
You can use these two pieces of information to know the target amount to save up to that will generate the income stream you need in retirement. This process of taking money out of your savings is called annuitizing your savings.
But once you know the target amount to save up to, you’d want to bring that amount to the present assuming reasonable rates of return. You’d then subtract from that what you have already saved and that difference is the amount you’d want to save more of between now and when you retire.
So say you are 50 years old and have $1.75 million saved, spread across a few accounts. And you want to retire in 10 years and draw $75,000 in inflation-adjusted income for 40 years in retirement. That is planning for 100-year life expectancy that we talked about.
So how much more would you need to save each year till you retire? Crunching the numbers gets us $32,000 that you have to save more of each year till you retire.
But say with everything remaining the same, you want more spending buffer that allows you to draw $100,000 in income from your savings. That will now require you to save $130,000 each year.
How is that possible? All you wanted is $25,000 more spending power but why do you have to save four times more? That is because you are drawing $25,000 more in inflation-adjusted money from your portfolio for 40 years in retirement but you only have 10 years to save for that. And the amount you have to save is four times more due to how compound interest works.
But say you delay retirement by two years to age 62. To guarantee the same $75,000 in income stream for now 38 years in retirement, you only have to save $5,000 more each year.
For $100,000 of income, you’d need to save $80,000 more each year. That is a far cry from $130,000 required before. Two years of working more eases things quite a bit.
Knowing how much to save for a big goal like retirement sorts other things out in life. Once you know that you are on track, you can then spend freely on things that matter in the present knowing that the future is taken care of.
Thank you for your time.
Cover image credit – Vlada Karpovich, Pexels