How to determine how much assets you need to retire
How much money one need for retirement is a questions everyone need to answer at some point. Maybe you are trying to figure out if you can afford to retire early. Maybe your retirement age is fixed by regulations from your pension scheme or your employer. Even in this case, you should know if your retirement fund are sufficient to allow for the retirement lifestyle you desire. Unfortunately, this question is not easy to answer and the result will be a different figure for each individual. Although some rule-of-thumb figures might be out there, I will not state a figure here and instead state the questions one must answer to calculate the individual funding requirements.
Accounting for your lifestyle
At first, you will have to estimate how much money you will need on an annual basis. This must account for the lifestyle you will have gotten used to by that time as well as additional needs you will have as a senior.
For example, staying in a cheap hostel when traveling in acceptable for a twenty-year-old, but at the age of sixty or seventy, you are more likely to demand a nice hotel room instead. Also, do not underestimate the cost of health care at a higher age. Gain an understanding of what seniors today pay in the country you choose to live in and account for increased life expectancy and additional diagnostics and treatment options.
You already know how much money you are spending today (total cost of living). Based on this, try to find out what your cost of living will be after retirement. You can cut back on work related cost like commuting or office clothes. On the other hand, you will have more spare time to spend on your hobbies. Maybe you will want to spend the winters in a different location than the summers. You might also have the option to move to a cheaper location in an area with less job opportunities. Having all these questions answered, you should be able to estimate the annual budget you will need during your retirement. Make sure you have some contingency, unforeseen emergencies do occur also while you’re retired.
The long-term effect of inflation
Once you have figured out the annual budget for your intended lifestyle, calculating the effect of inflation will make your estimation difficult. The timespan we are talking about is between twenty and sixty years, so leaving inflation out of the equation would lead to completely wrong results. In some industrialized countries, people are not used to accounting for inflation after decades of very low inflation rates. In other countries, inflation has continuously exceeded 10%. Either way, it is important to understand that low inflation rates in the past are not guaranteed to continue. Given the amount of debt in the US and Europe, it is obvious that the amount of the US-Dollar and the european currencies will increase further and that they will loose value at the same time. This process will continue at least over the next decade and will be so slow that it will be easy - even for experts - to deny that it is happening.
Let’s assume you plan to retire at the age of 65 and live to an age of ninety, the duration of your retirement is twenty-five years. With an inflation rate of only 3%, your retirement funds will loose more than half of its value over this period of time; At 4% it looses two thirds and at 7% about 84% of its value. These calculations show how significant the impact of inflation is over the long run. With the choice of investments, we must try to offset parts of the effect, but this can only reduce the effect.
You should state an assumption of what the average inflation will be in your country over the next decades and base your further calculations on it. This assumption can be based on the historic inflation rates and your judgement of the economic outlook for the future, demographics as well as the impact of globalization on your country.
Pick a random year (an easy choice is the current your) to baseline all your calculations upon and discount future years with your assumed inflation rate. The expected cost of living will be stable on the baselined value although the actual numbers will increase over time. Your retirement funding will be subject to inflation as well as the yield accumulated over time.
Putting it all together
So by now you have estimated the amount X of value (baselined amount in your currency) you require annually during your retirement. With the - very dangerous - assumption that the positive yield of your investments will offset inflation (thus, the yield after inflation will always be positive), we simply subtract the inflation from the expected yield of the investments. (However, this is overly simplified as you will have to pay taxes on the yield without being allowed to deduct the inflation). The result will be a surprisingly low yield that you can expect from your assets.
The most simple approach now would be that the yield (after inflation) should cover you cost of living (Example: annual cost of living: 45 kUSD, expected yield after inflation 3%, required assets 1.5 mUSD). This would financially allow you to live forever. If you are certain that you will die before reaching a certain age, and you do not wish to pass on your wealth within the family, you can also increase the rate of spending above the yield you earn. However, depending on how important sound financials are for your emotional well-being, I believe it is better to work a little longer, save a little more, spend a little less (or later). The calculation pointed out here shows the minimum you need based on your assumptions, not necessarily the recommended amount.
How much money do I need
Feb 17, 2012