The Simple Dollar is running a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.
Rule #10: Aim to build a retirement nest egg that is 25 times the annual investment income you need. So if you want $40,000 a year to supplement Social Security and a pension, you must save $1 million.
In terms of the actual calculation, this is spot-on: if you want an annual income from a retirement account, you need to have 25 times that much in the account to have that annual income last in perpetuity with inflation adjustments. This is because a well-invested retirement plan should earn 4% plus the rate of inflation, so if you withdraw that 4% each year, your balance will go up by the amount of inflation.
The only caveat is that it assumes that you’ll have additional sources of income in retirement, such as Social Security and a pension, options that might not be available when Generation Y makes it to retirement. I have no faith in Social Security or a pension, so what do I do?
The answer is to put enough in your retirement plan so that you’ll have 25 times the annual income you’ll need in the account when you retire. Let’s say you want an overall income of $60,000 in retirement. That means that you’ll need to have $1.5 million in retirement. That seems like a lot of money, but if you start young, it’s easily attainable, especially if you have company matching available to you. Plus, if you do have Social Security, it’s gravy on top of the mashed potatoes.
There is one additional part that you need to consider, though, when using such a rule: it does not account for inflation. If you really need to know what you’ll need per year when you retire to maintain the salary you have now, you need to increase that amount by the rate of inflation (figure 3.5%) for each year between now and retirement. If it’s a long time until retirement, then you’ll definitely need to increase your estimations.
Given that caveat, let’s rewrite the rule.
Rewritten Rule #10: Aim to build a retirement plan that contains 25 times the annual amount you want to have when you retire. So, if you want a total income of $60,000 each year when you retire, you need to have $1.5 million in your retirement account.