in which 12-year-old Preston writes himself a check for$1 million and lives in the lap of luxury.Even in 1994,when the movie was made, it was absurd to think he could buy the things he did with just $1 million (amansion, a batting cage, and ago-kart track with cash left over). Thatwasn’t reality.
And today, the truth is, even $2 million isn’t as much money as we think it is.
When we plan for retirement, we focus on how much money we think we’ll need.
Unfortunately, we underestimate that number. We assume our expenses will fall, that we’ll earn a certainrate of return, and that Social Security will fill in the gap. But we often underestimate our expenses and altogether fail to consider inflation, taxes, investment risk, and the chance that we could live a long, long time.
This is why you willneed at least$2 million to retire.
Inflation
It’s funny: We all know inflation exists, but werarely talk about itwhen planning for retirement. We like to think of a number to shoot for in retirement, right? But we’re not always considering the crazy effects inflation can have on our portfolio.
The inflation rate tells us how much the cost of goods and services is rising (or in some cases, falling) each year. This has a direct impact on our spending power—in other words, how much our money is worth.Investopedia gives a great example:
“As a result of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 2 percent, then a pack of gum that costs $1 in a given year will cost $1.02 the next year. As goods and services require more money to purchase, the implicit value of that money falls.”
Thatlatte that costs $5 today might cost $14 in retirement.
As you’ll read below, the recommended withdrawal rate in retirement takes inflation into account. But you still need to keep this in the front of your mind when you’re considering if $2 million is enough to retire on.
Let’s go a little further with this…
Say you plan on having $750,000 at retirement age, not accounting for inflation. So you’re using $750,000 in today’s money. That’s a reasonable retirement goal.
Using the Bureau of Labor Statistic’s inflation calculator, $750,000 today was worth around$2.2 million in 1980. That’s 35 years ago, which may be how long you have until your retirement.
If we use a calculator to projectfuture inflation, the outcome may shock you.Using anaverage inflation rate of 3%, the calculation shows you’ll need $2.1 million in savings to equal the purchasing power of $750,000 today. In other words, your $750,000 projected retirement figure might be way off.
Market risk
If you want tohave a semblance of a chance at beating inflation,you’re going to need to invest.Although thestock market still provides the best way for investors to earn a strong long-term return on their money, it comes with risk.
Perhaps the most significant risk isretiring at the wrong time. Choosing the right year to retire can have a significant impact on your cash flow in retirement. For example, someone whor*tired in 2007 would have seen their nest egg cut by a third or morein the recession that began in 2008.On the flip side, someone whor*tired the late-70s was able to enjoy the booming market of the 80sand likely had a more comfortable retirement thanthey had expected.
Nobodycanpredict what the stock market will do, butproper planning can ensure you’re insulated from the biggest blows when you need your money most. We recommend takinga long-term and low cost approach to investing. You can do this in a number of ways, but index funds may be the cheapest and the easiest. Most importantly, rebalancing your portfolio annuallyto maintainthe right asset allocation for your age and risk tolerance will keep you on pace and reduce risk as you get closer to retirement.
Withdrawal rate
A major thing you’ll need to consider during retirement is your rate of withdrawal. This is the percentage of your portfoliothat you will withdraw each year to cover expenses.
There is much debate around the right withdrawal rate. But there is no answer.Your withdrawal rate will depend on you. You need to consider things like:
- Your lifestyle in retirement (Maui or Boise?)
- Your retirement age (45, 65 or 75?)
- Other sources of income
Your withdrawal rate is personal.But as an example, let’s consider thewithdrawal rate of 4%, which has been popularized by early retirement blogger Mr. Money Mustache.
An influential 1998 paper known as theTrinity Studylooked athow much we need to live onin retirement. The study looked at historical stock returns and other factors to find that 4% was a ‘worst-case’ scenario. Meaning, you could withdraw 4% of your portfolio per year and live just fine in retirement.
This factors in an average inflation rate of 3% but accounts for an indeterminate period of time. That means that the 4% rule should hold whether you retire at 35 or 70.
Our take is this: The earlier you hope to retire, the more you have to factor in market risk; 4% might cut it too close. The longer you work and save, the less likely it becomes that you will outlive your principal.
Spending in retirement
A common retirement planning “rule” that is thrown around says you should save enoughfor retirement to replace80% of your annual pre-retirement income. But that rule is misleading.
First and foremost, you should plan your retirement based on your expenses, not income. If you earn $100,000 at age 55 but are saving half of it, you conceivably don’t need $80,000 a year (80% of $100,000) after you retire. Unless you’re going to spend more in retirement than before it.
Yes, the80% rule is misleading because it focuses on income, not expenses. But it couldbe dangerous to simply replace “income” with “expenses” and save enough to replace 80% of your pre-retirement annual expenses.
For lots of reasons, logicsuggests that the average person will spend less in retirement. Perhaps the mortgage is paid off and gone are thedays of paying college tuition for your kids (if you had them). You may very well drive less if you no longer need to commute to work.
But consider, too, that some expenses might go up. You will, after all, have a lot of newfound time to pursue your interests. Somepeople hope to travel in retirement, which is not inexpensive. There are also medical expenses associated with getting older to worry about.
A solid retirement plan shouldn’t rely on your expenses today but a realistic estimate of your expenses after you retire. When in doubt, it’s bestto expect you’ll spend more than you might think.
Life expectancy
We’re living longer now than we ever have before. In 2012, the average life expectancy hit 78.8 years, a record high. To break it down a little further, women are living, on average, 81 years while men are living, on average, 76 years.
Thismeans:
- You’ll need your nest egg to last longer
- You should be prepared for costs associated with aging, like long-term care
Sure, we have things like Social Security and Medicare to help supplement our retirement income today. But as we saw with inflation, things change in the future. Who knows what these programs will look like in 30 to 40 years, or if they’ll even be in existence.
Knowing that you’ll be living longer, you need to consider some different factors to see if the $2 million figure is enough. Here are a few:
Your health
If you live off cheeseburgers and fries, odds are you’ll have more health expenses later. Yes, it might be more expensive to buy locally grown, organic produce today. But you need to consider the cost savings on health-related issues in the futureby eating better. So quit going to the drive through and start making a clean-eating grocery list and cooking for yourself.
How active you are
One study showed that those who are active and exercise more will live longer than those who don’t. If you’re already a fitness nut, plan on living longer than your couch-potato counterparts. If you aren’t one who regularly exercises, get started now. You don’t have to run full marathons, but you can ride a bike or even do some gardening for a couple of hours. Both of these simple tasks will help you live longer.
Where you’ll want to live
Don’t just consider your geographic location. When you’re ready to retire, you’ll need to think about what’s around you. Will you live in a retirement community or a house boat in the middle of nowhere? Do you have family nearby? Will you need a car or can you survive by walking and biking? These things can all impact the dollar amount you’ll need to have stashed. A retirement community, for instance, can set you back almost $3,000 a month.
Summary
Inflation, market risk, withdrawal rate, unexpected expenses in retirement, and increasing life expectancy are all factors that suggest you may need as much as $2 million to retire comfortably. That number may scare you, but it’s a reminder to ensure you’re making the right financial moves today.
If you’re not sure where to start, consider an app like Wealthfront, which lets you automate both your savings and investing efforts seamlessly.
