Annoying disclaimer: I’m not a financial advisor, and I’m definitely not your financial advisor or investment advisor. All investments can lose money. Proceed at your own risk.
65% of respondents to our survey said they save for retirement every month, but when asked “how much do you expect to need for retirement”, 50% said “I’m not sure.” There are two questions to address for retirement: “how much do I need” and “how do I know that I’m saving enough?” By the end of the section, you’ll have set a realistic target and have a plan for working toward your target.
Let’s demystify retirement planning. Getting ready for retirement is not much different from any other planning and the principles used to save for a $300 watch or a $3,000 ring or a $3,000,000 retirement remain the same – you need to set a goal and work backward from that number to save money each month. Of course, there are some differences. For one, the amount of time involved in planning for retirement is enormous, which makes the goal feel ‘impossibly far away’ until it feels ‘impossibly close.’ Second are the stakes. When saving for a $3000 ring, there’s only one milestone – the day $3,000 is available in the account. By contrast, saving for retirement has two milestones – one day when you no longer need to work and another day when you no longer can work.
How much do I need?
If you leave this book with nothing else, I hope you leave with this: you need to set a meaningful target amount for retirement. If you were writing the goal on paper, it might sound like “I will have $X saved for retirement on January 1, 20XX” The number must be one which you (1) believe would allow you to spend the rest of your life without receiving another paycheck and (2) believe can become a realistic target.
Molly and my goal for retirement is $1,100,000 and a paid-off house on July 1, 2050, which is at the time of this writing. This will allow us to be in order to not need to receive a paycheck to continue with our monthly expenses.
How did we get to that target number? By using the 4% distribution estimate.
The 4% Distribution estimate
The “4%” distribution estimate says that the typical investor can withdraw 4% of their portfolio each year and expect their assets to remain stable for the long-term. In other words, with $1.1M in assets, you could plan to withdraw up to $44,000 per year without exposing yourself to too much risk.
This is more commonly called the 4% “rule”, and it comes from research done by Bill Bengen on distribution strategy in retirement, originally published in 1994 in the Journal of Financial Planning. More recent researchers think 4% may be too aggressive. Since I’m still 20+ years away from retiring, I’m using 4% as a useful benchmark with the understanding that we live in a changing world, and 4% may be the wrong number.
Here’s what the math looks like:
($1.1M assets) * (4% withdrawal rate) = ($44k annual expenses)
Or if you’re trying to go the other direction to determine how much you need based on a certain expense amount, the math is the same:
($44,000 annual expenses) / (4% withdrawal rate) = ($1,100,000 assets)
Molly and I estimate that we need $44k/year to live in retirement on a $3,700/month budget. Assuming we don’t have to pay a mortgage, it would be quite possible for us to live comfortably on $3,700, while preserving the $1.1M assets long into retirement. Of course, we would only withdraw what we need for a given month, while targeting an average of $3,700 over the long-term.
Now it’s your turn to use this formula. If you needed to retire now, how much would you need to spend per month? For people in their teens or twenties, your expenses may not be a good benchmark for how much you’ll be spending in later years, especially if you’re not paying for expenses like health insurance or a long-term home. If that number feels hard to invent, feel free to borrow mine for now – $3,700/month or about $44,000 per year. From there, divide your spend number by 4% to estimate your total needed retirement amount.
As a helpful benchmark, the folks at Fidelity recommend aiming to save 1x your income for retirement at 30 and 2x your income at 35. In other words, if you make $50,000/year, aim to have $50,000 saved for retirement at the age of 30 and $100,000 saved at the age of 35. If you’re thinking “I’m nowhere near that number,” then it’s time to get focused on making your assets to work for you.
I once asked a 30-year-old how much he had saved specifically for retirement and he said, “nothing, it’s all in play right now.” He meant that he wasn’t using a tax-advantaged account to save specifically for retirement because it feels restrictive – who wants to put money into an account which they can’t access for 35 years? The problem is that human nature will tend to want to “take advantage” of the money sooner, which could put long-term plans at risk. Retirement savings should be in a tax-advantaged investment retirement account like a Roth IRA, and should represent money which will do nothing other than sit in the market from now until retirement. The foolish person says “I’ll save for retirement in a few years.” But the wise people who do the same boring thing, month after month, year after year get the reward of compound interest.
Considering Inflation
We set our retirement target using “today’s dollars,” which is a reference to inflation. Since 1990, the cost of living has grown 2.4% per year due to inflation, a process which will continue for as long as we have a stable economy. As an aside, inflation is an important feature of our economy that provides predictable flows of money in the markets. The Federal Reserve (“The Fed”) works hard to keep US inflation around 2% and dipping below 0% into “deflation” would be terrible for our economy. Brief periods of higher inflation, like were experienced in 2021, are worse politically than they are for the actual economy.
In 30 years, my $1.1 million asset need will double to become a $2.2 million asset need as a result of inflation. While that feels like an absurd amount of money right now, the good news is that we have compound interest at our back, so getting to $2.2M won’t be as impossible as it sounds. Rather than try to imagine what $2.2M will feel like in 30 years when all prices have doubled as well, we can express our retirement goal as if we were retiring today and factor inflation into our calculations.
When we arrive at our actual retirement date, the real number in our bank account will be closer to $2.2 million, since they both have the same .
($2.2 million in 2052) = ($1.1 million in 2022) + (30 years of inflation)
What about Social Security?
It’s hard to imagine a world in which social security goes away entirely, but it’s also hard to imagine how the federal government is going to sustain the program. In the 1930’s, the people who invented social security assumed a certain birth rate and life expectancy. As America has gotten wealthier since 1950, birth rates have dropped in half and life expectancy is up about 11%. This creates a nation-sized math problem. Today’s retirees were promised a level of income based on the expectation that they would have twice as many babies and die eight years earlier. Just considering the extra eight years of average social security benefits amounts to around $175,000 per retiree. What we as a nation do about this problem remains uncertain, but something will happen. If you are planning to retire after 2040, expect some dilution in total social security benefit. This dilution will happen either in absolute terms – “we promised you X but now you get 50% less” – or in relative terms – “we’re going to inflate the entire economy so every dollar is worth less, and we can keep our nominal promises.” My personal, unsubstantiated guess is the relative option.
For what it’s worth, If someone retired today at age 70 and was earning $50k/year, they would be eligible for around $1,800/month in retirement. If you want to do more calculations on social security benefits, the Social Security Administration has a calculator.
If you want to include social security as part of your retirement plan, that’s your prerogative. We have chosen not to include it in our anticipated retirement amount because it’s hard to know what the political landscape will look like when we hope to retire in 28 years. If social security ends up being a piece of our retirement, we’ll consider it an opportunity to give more than we expected.
How should I practically save for retirement?
Now that you have a target total number for your retirement savings, let’s start working toward the target. SInce we’re estimating for the long-term, we need to make a (big) guess about how much our money will grow each year, on average. This is the “estimated annual return.” We’re going to use 6.5% as our estimated annual return on investment after inflation. In other words, we expect that each year, on average, our invested portfolio will return 6.5%. Some years will see massive gains and other years will see massive losses, all of which average out to a slow but real growth.
Use your employer’s retirement plan, probably
A lot of employers offer retirement plans with a matching program - if you put in 6%, they’ll put in 3%. This is often a good deal, because the 3% is literally free money. However, some programs have vesting periods, where you have to continue to work at the job for a certain period of time before you earn the bonus money. These vesting schedules can be as long as 4 years, which can become a problem when it is time to change jobs. You will need to consider your specific situation but oftentimes the retirement plan is a pretty good deal.
Create another retirement account
In addition to having a retirement account with work, consider opening one personally as well. This makes it easy to save for retirement, even in very small amounts, separately from work.
The practical process of creating a retirement account may be obvious to you but it was not obvious to me. You can create a retirement account online, without talking to anybody, for free.
Start by picking an investment firm. I like Ally or Vanguard but it probably doesn’t matter very much which firm you choose.
Then, create an investment account with them. The account can have a special tax designation called either a “Roth IRA” or a “Traditional IRA”, but you can also create an investment account without any special designations.
Finally, choose what assets you’re going to purchase. Just like your savings and checking accounts hold cash, investment accounts hold stocks, bonds, and funds.
For example, Molly and I have two investment accounts with Ally: one is a general investment account and the other is a Roth IRA. The Roth IRA allows us to pay taxes on the money we put in now (“principal”) to avoid needing to pay capital gains tax on it when we retire. The investment account does not have any special tax benefits. Within those accounts, we own shares of two low-cost index funds, which are the only funds we hold in those accounts. We aren’t managing a complicated portfolio of stocks.
What should I invest in?
John Bogle, the founder of Vanguard, wrote “Don’t look for the needle in the haystack. Just buy the haystack!” His book The Little Book of Common Sense Investing is worth reading as a much more comprehensive treatment on what to buy in the market.
There’s a lot of great writing on investing and this book is not going to get you to “expert.” The good news is that you don’t need to be an expert. Planning for an annual return of 6.5% should be doable without spending hours picking stocks or reading financial reports. You’re not trying to win at investing, you’re just trying to take advantage of the power and productivity of the American economy.
Rather than try to “pick” winners, index funds buy little bits of many companies. This can help you feel confident in your investments without needing to pay a professional.
There are two important pieces to picking a fund: (1) the selection strategy and (2) the cost or expense ratio. The selection strategy is how the index fund determines which stocks it holds. One interesting thing to consider is a target date fund, which automatically adjusts the risk profile of the fund to (hopefully) mitigate severe losses as the target date approaches. The idea is that holding a volatile portfolio is optimal when you’re 30 years from retirement because you would have enough time to make up for big losses during particularly bad years. The expense ratio is the annual percentage paid to the fund as a fee for their service. An expense ratio of 0.15% is fantastic. An expense ratio of 1% or higher is highway robbery. If you’re investing with a company retirement plan, sometimes they offer a limited selection of fund options which charge higher expense ratios. Just keep in mind when choosing funds that expense ratios are a significantly bigger deal than they seem. The funds we invest in carry between 0.05-0.15% expense ratio, except for my employer’s 401(k) which has a target date fund with a 0.4% expense ratio.
Do I need a financial advisor?
Lots of people will want to talk to you about your money at various points in life and they all have different . It’s critically important to understand what those incentives are, so you don’t end up paying people for the rest of your life who helped you once for a couple hours on a Tuesday. It can feel uncomfortable but it’s worth asking people how they get paid for their services, and how much they expect to make from dealing with you.
I once met with a financial advisor for a few sessions when Molly and I had just gotten married. He talked all about how he was a Christian and described himself as a “fiduciary” which was supposed to make me feel better because he would only act “in my interest” by law. He wanted to help us with our budget. In our third session, he quoted CS Lewis and literally teared up a little. Finally when it was time for him to recommend a plan, he suggested that we buy “whole life” insurance through his company, paid for by refinancing our house. Even though we were in $100,000 in student debt, newly married, and genuinely trying to figure out how to stay afloat, his top priority for our financial future was a terrible life insurance policy and an expensive home refinance because those products print money for their salesmen.
I still get angry thinking about it.
Dave Ramsey was asked about Whole LIfe insurance and his words were: “It sucks!” Insurance is a topic for another book, but it’s generally best to steer clear of advisors who are pulling double duty as financial advisors and insurance salesmen. These people stand to earn thousands of dollars in commission when you sign a long-term insurance contract; commission which is ultimately coming out of your paycheck.
There’s nothing wrong with using a financial advisor, but consider their costs. If you want someone to come to your house for a day to fix your plumbing, it’s going to cost $1,000 at the end of the day. Likewise, even though we often don’t see the fees taken by financial advisors directly, the fees are still there. If you’re just starting with investing, you’re probably better served by putting your invested money into a low-cost index fund, using a Roth IRA, and spending most of your energy focused on building assets through education and creativity than the stock market.
Process over results
Everyone feels like a genius when the market is going up and everyone feels like an idiot when the market is going down even though it is utterly unknowable what the market will do tomorrow. You don’t know. I don’t know. The market doesn’t know. Dave Ramsey doesn’t know. Jim Cramer doesn’t know. Wall Street doesn’t know. The president of the United States doesn’t know. Tons of nerds have spent their entire careers trying to find new ways to predict the market and each time somebody finds a “cool new trick”, it often backfires. It’s a quirk of human nature that we “feel” like we know what will happen next when looking at a chart. “The stock is low right now,” we think, “so maybe I should buy the dip.” Our minds grab onto overly simplistic stories, which can trick us into thinking that a particular stock is “low” or “high” by looking at the shape of a graph. It is possible to develop a guess about a business, especially one which you know a lot about. But you don’t know. The book What I Learned Losing a Million Dollars by Jim Paul is an entertaining memoir about someone who knew more about investing than almost anyone and still lost everything. If you have a tendency to gamble with your money, it’s worth a read.
Since you don’t know what will happen next, your investment strategy needs to focus on the process of decision making, not short-term results. It’s possible that you will invest $1,000 this year, lose 20% of it next year, and still have made the right decision. Here’s my core investment strategy: “buy boring index funds and never, ever sell.” With our retirement, we’re planning for the long-term. Day to day and year to year swings in the value of a stock will come and go like the tide on the beach, all while representing big changes for your portfolio. It’s up to you to have the discipline to trust the process.
Warren Buffett said “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Investors tend to go crazy and overhype certain stocks until something negative happens and then they go crazy and underhype them. But eventually, all stocks must answer for the earnings of the companies they represent.
As the adage goes, “time in market beats timing the market.” When the COVID-19 pandemic hit in the spring of 2020, I got nervous along with everyone else. I sold a bunch of stock right after the market had lost a significant amount, because I thought an extended business closure would have a big impact on earnings. What I didn’t expect was the government to intervene as much as it did, effectively giving the market and economy steroids. Six months later, the people who didn’t sell were up 20% while I was “playing it safe” holding my money in cash.
It’s important to note that my core investment strategy isn’t a “junior varsity” strategy. Buying index funds and holding them is used by everyday millionaires all across America, as well as some of the biggest investors in the world. You can go all the way to retirement by only investing in boring stocks, with no need to “graduate” to a more active management approach.