How Large Does Your Retirement Nest Egg Need To Be?

   There was a time when it was standard for companies to offer pensions to their employees so that after many years of faithful service, they could retire in dignity. This was a blessing for a generation, but it is rare now. The problem this has caused is that many parents never taught their children the value of saving for the future. Conventional wisdom for a time was to get a job with a good company, work for them for 30 years, and they will take care of your retirement. But now most companies have moved away from defined-benefit programs like pensions to defined contribution programs like the 401k. The 401k can be a great tool for securing your retirement, but it requires each worker to pay attention to their investments.

   Another thing a lot of people count on is Social Security. But Social Security benefits only cover 38% of the working income of the average earner in the US. If all you had was Social Security you would not be able to maintain your lifestyle. Instead of living out your retirement dreams, you would be living in poverty. Social Security can be a part of your retirement plan, but only a part.

   How much savings you need to retire depends on what fixed income you expect (Social Security plus pension if you are so lucky), your retirement budget, your rate of return, and whether you want your nest egg to last forever or whether you plan to draw it down to nothing (hopefully after you don’t need it anymore).

Step One: Budget for the Life You Want!

   I’ve written about Budgeting 101 and shared how you need to be in control of your budget if you want to achieve your financial goals, like retirement. But you also need to have your future budget in mind. What do you want to be able to do with your life in retirement? How much will it cost? Make sure you include all of your life goals.

   Our current expenses total less than $4,000 a month, but my wife and I are living pretty lean right now. During one dreaming session, we came up with the number $7,000 a month, so we could expand our giving and do all the travel we want. I will use these numbers as the high and low targets for my examples later on.

Step Two: Pick Good Investments!

   A good rule of thumb is don’t invest in anything you don’t understand. Bernie Madoff ran a very dependable wealth management firm using a strategy he called “split-strike conversion.” His investors didn’t really understand what he was doing or how he was getting the returns he delivered, but he delivered dependable returns on his clients’ investments for years. Unfortunately, his real strategy was lying. When the market crashed in 2008 many of his clients needed their principal back from him, but he did not have the money. He depended on new money from new investors to pay old investors in a fraud called a “Ponzi” scheme.

   So the moral of the story is don’t invest in anything you don’t understand. But don’t let that stop you from investing in something. You will have to educate yourself at least a little bit in at least one wealth-building investment strategy.

   There are many places to invest your money and I will write about some of them in a later blog. However, for this example, I will use the investment strategy I understand the best: diversified growth stock mutual funds.

   I prefer this method because it provides the opportunity to only live on the growth and dividends from my investments and not dip into the principle, making a nest egg that endures to become a legacy.

   I anticipate an average ten percent annual return, after subtracting inflation. I subtract inflation so I can see what my nest egg will look like in today’s dollars. I know that my account balance will actually be larger in the future, but the spending power will be the same. It is easier for me to subtract the growth than to add the decades of inflation to my retirement budget.

Step Three: Account for Taxes!

   Depending on where you are investing you will probably have to pay taxes on the income your investments generate. Rental income is taxed as regular income, so the tax rate depends on your tax bracket. Luckily you can subtract all of your expenses associated with the property so you only pay taxes on the net.

Capital gains taxes are 15% to the federal government and are variable depending on the state in which you file taxes. For example, California taxes capital gains as regular income. You pay capital gains when you take money out of your investments (sell real estate, stocks, or bonds), so you need to include these taxes in your retirement plan.

You can avoid some taxes by using a retirement account. An Individual Retirement Account (IRA) is an account that you have with your financial institution. Through this account, you can invest in whichever stocks, bonds, or mutual funds you want. There is a contribution limit of $6,000 per person per year and when you are 59 and a half, you can withdraw your money from your IRA without penalty. You can contribute pre-tax dollars to a Traditional IRA, which means you get a tax deduction on your contribution. But you will have to pay capital gains taxes on the growth of your investment when you sell. However, a Roth IRA is my favorite option, because you fund it with money that you already paid taxes on, so there are no additional taxes when you start taking money out in retirement.

Once you have an idea of what your tax rate is going to be you can include it in your nest egg calculation.

Step Four: Anticipate Your Fixed Income

   Your fixed income is any guaranteed monthly income that you will have in retirement. The most common examples are Social Security or pensions, but you might also have a legal settlement like alimony, or an inheritance that has a slow payout.

Social Security

   If you paid into Social Security, you will probably be getting something from them in retirement. Personally, I would rather not have to count on Social Security. I would prefer to have it as a bonus that allows me to be extra generous in retirement. But I know that some people who have started planning for retirement late are going to need that money to cover their normal expenses. So it is okay to have that as part of the plan. Just keep in mind that there are projections that Social Security will “run out of money” by 2035 if Congress doesn’t do anything to change it. But “run out of money” just means that the savings will be gone. It will still have workers paying into it as retirees draw out of it, which is enough to support 75% of its obligations, so if you had a $1,000 benefit, you would be down to a $750 benefit after 2035.

It is up to you whether you want to include Social Security in your calculations. But if you are younger I suggest you leave it out for now. It is better to save more and not need it than to need more and not have it saved.

Step Five: Calculate Your Nest Egg!

   Your nest egg is going to be all of your invested assets that are generating your income plus your emergency fund that covers a temporary failure of your assets to produce (such as in a recession).

I’ll show you how to use these simple formulas to estimate what your nest egg needs to be:

Annual Fixed Income =
(Monthly Social Security + Pension + Any other guaranteed benefit) * 12

Invested Assets =
(Annual Budget – Annual Fixed Income) / (Rate of Return * (1-Tax Rate))

Emergency Fund =
(Monthly Budget – Monthly Fixed Income) * (Number of Months Protected)

Nest Egg =
Invested Assets + Emergency Fund

Example – My Ideal Retirement:

   I am investing in something I understand, so I have the confidence to know my average rate of return. I expect my growth stock mutual fund portfolio to grow by at least 10% annually after subtracting inflation. If all my money is in my Roth IRA and I am 59 and a half, then my tax rate is 0%. I want a budget of $7,000 a month, so $84,000 a year. Also, at this point, I am not counting on anything from Social Security. I will probably get something, but I want it to be an extra bonus, not a necessity; so for my nest egg calculation, I will set my Annual Fixed Income to $0.

Invested Assets =
(Annual Budget – Annual Fixed Income) / (Rate of Return * (1-Tax Rate))

My Investment:
($84,000 – $0) / (10% * (1-0%)) = $840,000

That means I want to have at least $840,000 invested in my Roth IRA when I retire. This principle should grow enough to keep up with inflation while I am taking the future equivalent of $7,000 out each month.

Because returns are never guaranteed, I also want to protect myself against any bad months or a full-blown recession. I understand my investment and so I understand its risks. My average returns might be 10% after inflation, but that will not be true every year so I need an emergency fund to protect myself against the risk of losing money or not growing during a recession. Recessions generally last from 3 to 18 months, with the average lasting about 11 months. There have been a couple of notable exceptions: in 1893, there was a four-year-long depression and of course, there was the Great Depression which started in 1929 and lasted 9 years. But I think 2 years of reserves is enough to protect me from the most likely recessions. I could increase this if I want more security.

Your emergency fund is your insurance against a loss of income.

Emergency Fund =
Monthly Budget * Number of Months Protected

My Emergency Fund:
$7,000 * 24 = $168,000

So I’ll make a $168,000 emergency fund to live on whenever the market goes negative, whether for a few months or a couple of years. I want to avoid drawing money out when the investment principle is less than $840,000 otherwise I’m using the principle and not the growth.

Nest Egg =
Invested Assets + Emergency Fund

My Nest Egg:
$840,000 + $168,000 = $1,008,000

Based on my retirement budget, emergency fund, and my average rate of return, my nest egg should be at least $1,008,000, by the time I retire – if I want it to last forever.

What happens when I withdraw more than my account grows each year?

   The reason I use my average expected growth as part of the investment formula is so that I only live off of the growth, interest, and dividends and my account can last basically forever. If I didn’t have enough growth to support my lifestyle, then I would be drawing from the principle and reducing my future earnings as well as putting an end date on my account balance.

For example, if my principle is only $800,000 and it grows 10%, that means I can spend $80,000 without reducing my nest egg. But my budget is actually $84,000 a year so I take $4,000 from the principal to make up the difference. That’s not a lot at first, but then the next year I have $400 less in growth and I have to take that much more from the principal. That imbalance will keep growing each year until my principle is completely gone, which would happen after 30 years.

If I am okay with my money dwindling to nothing by the time I am 95 years old I would need the $800,000 invested when I am 65, as well as a $168,000 emergency fund for a total nest egg of $968,000. As you can see, the cost difference between a retirement investment that could last forever ($840,000) and one that dwindles ($800,000) is so small (only $40,000 or about 5% overall) that I definitely recommend aiming for it to last.

Other Scenarios:

Lower Budget

   For those who have a lower monthly target, the calculations will be the same but the total nest egg will look significantly different. If I just wanted my current budget of $4,000 a month but I still invest in growth funds that give an average 10% annual return, I would need $480,000 invested and $96,000 in an emergency fund for a total nest egg of $576,000.

Social Security

   Here’s an example of how I would account for Social Security in my nest egg calculation. I’ll assume I am eligible for the average Social Security benefit of $1,400 a month. However, I won’t be taking Social Security until well after 2035 so the benefit may be reduced to 75% of $1,400 which is $1,050 a month or $12,600 a year; I will use this lower number just in case. You can see how the addition of fixed income adjusts my nest egg requirements for a $7,000 monthly budget below.

Annual Fixed Income:
$1,050 * 12 = $12,600

Invested Assets:
($84,000 – $12,600) / (10% * (1-0%)) = $714,000

Emergency Fund:
($7,000 – $1050) * 24 = $142,800

Total Nest Egg:
$714,000+ $142,800 = $856,800

Different Investment

   If I wanted to invest in something safer that I still understand, I would choose real estate. Rental income is generally reliable but it’s also a lower overall return (around 4% annually) and I would need to pay income taxes on the net (which average 21% for CA and Federal combined). For this example, I will assume taxes on all of the income because it’s difficult to calculate what my deductions could be. My nest egg calculation for a $7,000 per month budget would look like this:

Total Real Estate Value:
$84,000 / (0.04 * (1-0.21)) = $2,658,228

Emergency Fund:
$7,000 * 12 = $84,000

Total Nest Egg:
$2,658,228 + 84,000 = $2,742,228

You don’t need as much of an emergency fund if you know your returns are going to be reliable, but the total nest egg still needs to be larger than if it was invested in something with a higher risk and higher average rate of return. The additional cost of taxes also increases the investment needed so it’s important to be familiar with the rules surrounding your investment strategy.

Next Steps

   Once you know what your minimum nest egg should be, you can move on to the next steps in retirement planning: choosing from different types of investments, building a nest egg, and learning what it takes to retire early. I will be posting about these topics next.

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