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Personal Finance FAQ

How Much Should I Be Saving?

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

In this article, we’ll look at how we pay for our living expenses when we’re no longer working and need to rely on our investments to provide us with money.

The question of when you can retire is one which is actually fairly simple to answer…if you have enough money. It’s when your passive income, in other words, income which you get as a result of your investments, annually exceeds the highest amount of expenses you could ever have in your lifetime. If you’re there, and you don’t want to work anymore, then you can go ahead and give your notice.

Most of us won’t get to the point where we have that much in assets before we retire. Thus, we’re going to have to take slightly more risk, since we’ll have to actually tap into our principal and hope (yes, hope) that our investments produce enough return so that we don’t run out of money before we run out of days on the planet.

There is no magic trick to investing money for retirement. It’s a function of two variables: how much time you have until you retire and your expected return on your investments. More time means you don’t have to save as much. A higher return means you don’t have to save as much.

While the S&P 500 has gained about 11 percent in the past century, it would be unwise to simply assume that is what you’re going to get every year. Returns fluctuate, and, unfortunately, it does not seem like we’re going to have the favorable economic conditions which allowed those returns in the foreseeable future.

The proper way to give an evaluation of savings strategies is to create a comprehensive model that uses Monte Carlo simulations. Monte Carlo simulations randomly choose outcomes of events which could happen and then tell you how your strategies work in a range of possible futures. One future may have a down year for your investments the first year you retire, and another future could have you living to age 103.

Building a Monte Carlo simulation is time-consuming. It requires understanding your specific situation and how different variables may affect you in ways that they would not affect other people. Everyone starts from a different point. Furthermore, Monte Carlo simulators require proprietary software – for example, I use an Excel-based Monte Carlo generator – meaning that building a basic spreadsheet in Excel or Google Documents to create a Monte Carlo simulation is almost impossible, though I have seen it done rather cleverly.

Thus, we have to adjust and simplify to adapt to the tools that we have at our disposal. The simplest way to do this is to adjust the expected rate of return downwards. The best way to do this is to use the Compound Average Growth Rate (CAGR). CAGR accounts for how much your investment actually grows over time. For example, let’s say that you invest $1,000. In the first year, it drops by 50%, leaving you with $500. In the second year, it gains 100%, leaving you with $1,000 again. Over the two years, a simple arithmetic average would say that you gained 25%: (100% – 50%) / 2 = 25%. In reality, your actual return was 0%; you’re right back where you started.

The CAGR[1] of the S&P 500 from 1871 to 2012 was 8.92%.[2] However, over the past decade, the CAGR of the S&P 500 has been 7.06%. Thus, a safer starting point for calculating your returns is to use a CAGR of 7.06%. Since CAGR reflects actual average growth rather than average rates, it’s more appropriate to use in the estimation of your investment returns.

When you did the exercise in “Retirement – Paying for Knee-High Socks and Hammocks” to determine the target number, you notice that I used a 5% expected rate of return. I did so to create an even more conservative estimate of the amount of money you would need to have a reasonable chance of success in retirement.

You can use an expected rate of return anywhere from 5% to 7.06% and be reasonably safe in your estimates.

“But…” you’re thinking, “that still doesn’t tell me how much I need to save!”

Patience, grasshopper. We have to understand why we have the “target number” and how we arrive at it before we can determine how much to save.

However, your patience is rewarded! Now it’s time to open up the spreadsheet for this article!

You will also need to open up the spreadsheet from “Retirement – Paying for Knee-High Socks and Hammocks” as well. The rate of return you use will affect the target number – the higher the rate of return, the lower the target number, so if you decide to deviate from 5%, you will need to input in a new target number.

The easiest way to input in the numbers for the first two cells is to use the following steps:

  1. Click on the cell (e.g. B1, B2)
  2. Type =
  3. Tab to the “Retirement – Paying for Knee-High Socks and Hammocks” spreadsheet
  4. Click on the relevant cell in the “Retirement – Paying for Knee-High Socks and Hammocks” spreadsheet (e.g. B19, B20)
  5. Press Enter/Return

You should get a formula which looks similar to this:

When you press Enter, the formula will automatically update to show the number from the cell in the “Retirement – Paying for Knee-High Socks and Hammocks” worksheet. Please note that I am using sample numbers for the examples below.

Next, you will enter in the number of years that you have until retirement. Round down. So, if you opened this spreadsheet in April, 2020 and planned on retiring in January, 2038, you’d have 19 years until retirement.

Then, you will need to enter in the total amount of investable assets that you have available. Do not include your personal residence in this number, as you’ll need it to live in. We’ll discuss how your personal residence may come into play in helping you meet your expenses shortly. Include all other investable assets, such as brokerage accounts, IRAs, 401k/403b/457, TSPs, and the like.

Once you have input these cells, you should get a number that shows up in cell B7.

This number represents how much you need to make up through annual saving and investing.

To calculate how much you need to save, you will need to use Excel’s Solver. Click on the Data tab in Excel.

Then, click on the What-If Analysis button.

Click on Goal Seek. A small window will pop up. Enter in the exact values as shown and click OK.

Once you do that, you should get a notification that Excel has found a solution. Click OK. Don’t worry if it shows ($0.00) or even $0.01.

You now know how much you will need to save annually.

If the number is $0.00 or less, then you can go back into the “Retirement – Paying for Knee-High Socks and Hammocks” spreadsheet and shorten the number of years until retirement. Alternatively, if you can save more, input in the amount you can save and go into the “Retirement – Paying for Knee-High Socks and Hammocks” spreadsheet and adjust the amount of time until retirement downwards to see how much less time you could potentially have to work.

You can keep iterating through the exercise, adjusting expenses, rates of return, and years until retirement until you’ve found a solution you can work with. The idea is to play with scenarios and see what is possible. If you’re able to sacrifice a little more and save a little more, you might be able to retire earlier. Don’t forget to adjust your Social Security number as well. If you retire earlier or later, it will probably affect the amount you will receive in Social Security.

If you can’t save the amount required, then you have three choices:

  1. Extend out your working career. This will lower the number of years that you have to account for in retirement where you won’t be making money, and it will give you more years in which to save up to reach that target number.
  2. Lower your expenses in retirement. Maybe it means only one trip per year to see the grandkids instead of two trips per year, or getting a fifth wheel rather than buying an RV. You get to control your discretionary spending, so if time off is more important to you than how luxuriously you spend that time, you can make those tradeoffs.
  3. Look at advanced strategies below.

Advanced Strategies: Annuities and Reverse Mortgages

Annuities

At its core, an annuity is a conversion of your assets into a stream of payments which will last you for the rest of your life. Annuities have a similarity with bonds in that they pay you monthly payments, just like a bond does. However, there are differences as well. The biggest difference is that a bond will eventually end its interest payments and return your original principal. With an annuity, you are paid monthly for as long as you (or you and your spouse) live, and when you die, there’s no return of principal.

Annuities typically pay higher rates than government bonds because they get to take advantage of the deaths of some of the participants. In the first year, the insurance company – those companies usually are the ones who issue annuities – will pay almost everyone. As each year passes, though, some of the people in the pool will die off, meaning fewer and fewer payments. As a result, annuity payments are a function of interest rates and your age when you purchase the annuity. The older you are, the higher the payments, and the higher the interest rate, the higher the payments.

Monkey Brain doesn’t like annuities because he likes to play the “what if” game, meaning he’ll question you about buying an annuity because the purchase is irrevocable, and what if you (or both you and your spouse) die the day after you buy the annuity? You’re going to regret it then, because you’ll have wasted all of that money!

You won’t.

You’ll be dead. You won’t care what’s happening back in this world because you won’t be around to observe it.

The other hang up that people have about purchasing annuities is the loss of control and the loss of the ability to bequeath that money to heirs.

If you don’t have enough money to pay your expenses using a safe withdrawal rate, what good will trying to leave a bequest do when you spend it all and then have to live with the kids when you’re old? It won’t do you any good. The money will disappear anyway.

Plus, your kids should learn to fend for themselves without relying on good ol’ Mom and Dad peeling the garlic to gift them a big inheritance.

Since annuities almost always pay out at a higher rate than a safe withdrawal rate, you can use the amount needed to purchase an annuity as a proxy for your “danger zone” in depleting your assets. Basically, as long as you can keep your asset base higher than the amount needed to buy an annuity, you’ll be in good shape. Once you hit that number, though, you either need to lower your expenses or you need to purchase the annuity.

When looking at an annuity, there are only two factors you need to consider: buying a single premium annuity and getting a joint annuity (if you’re married) that has an inflation rider, so the payments go up each year by the amount of inflation, thus locking in your purchasing power. You also want the annuity to be a qualified annuity so that you can receive most of the payments tax-free.

I recommend getting a 100% survivor benefit, but many couples get a 75% survivor benefit, since some expenses, like food and travel, don’t cost the same regardless of whether one or two people use them (compared to a house, which will have the same property taxes and income with one or with two people in it).

Let’s look at an example.

Bill is 67 and his wife Sue is 65. Their monthly expenses in retirement are $5,000 more than they receive in pension and Social Security income. If they were to purchase an annuity in April, 2012 with a joint life expectancy and an inflation rider at 3% to cover the $5,000 a month expenses, it would cost them slightly more than $1.46 million dollars. As long as they have more than that amount in assets (excluding the house), then they do not need to annuitize. If they drop down to $1.6 million, then they need to annuitize.

As they get older, the lump sum needed to purchase the annuity will drop. Let’s assume they’re 10 years older. The amount needed to get the same $5,000 monthly payment drops to $1.18 million. They would want to annuitize if their assets drop down to $1.25 million.

This is predicated on having sufficient long term care insurance and health insurance, as those are two expenses which can spike dramatically and suddenly if you do not have proper insurance for them.

Another way to consider annuities is to look at the floor of income which you need to live day to day – food, shelter, clothing, transportation, and health care. Other expenses are discretionary. For the fixed expenses, you can annuitize and then keep your remaining funds invested in equities to fund your discretionary expenses. If the market does well, you can expand your lifestyle. If it does not, then you contract your discretionary expenses.

An additional consideration is averaging into annuities. This works particularly well in a low interest rate environment – generally under 4% – and if you’re older – generally over 65. The rate of the increase in payments increases (for you calculus wonks, the first derivative increases), meaning that the gain, holding interest steady, from age 65 to 66 is less than the gain from age 66 to 67. Furthermore, if the interest rate is low, it should be expected to rise again. By incrementally purchasing annuities, you are able to preserve capital from being locked in at lower rates or at a younger age. I recommend increments of $100,000 or less, since $100,000 is the federally covered limit for annuity insurance.

If you really can’t envision giving chunks of money to an insurer, there is a second alternative.

Reverse mortgages

A reverse mortgage is an arrangement where the bank will allow you, the homeowner, to cash out the equity in your home and use it for as long as you remain in the home. In exchange, when you, or you and your spouse, leave the home – whether feet first, by moving into an assisted living or nursing home, or simply moving – the bank receives the home. Not everyone is eligible for a reverse mortgage, as you must be at least 62 years old in order to qualify to use one.

If you have a fully paid for house and sufficient long-term care insurance, a reverse mortgage can be a good way to tap into a source of cash and delay having to dip into retirement funds until later on. This strategy allows the retirement funds to continue to grow tax deferred or tax free.

There are several reverse mortgage programs, but the best one to use is the Home Equity Conversion Mortgage (HECM) Saver Line of Credit (LOC), which creates a line of credit for a very low closing cost. Instead of the usual line of credit, which must be paid back and can be closed off if the economy sinks, once you’ve opened up a HECM LOC, you cannot be denied by the bank. Additionally, in comparison to a home equity line of credit, a HECM LOC can continue to grow. Interest compounds in the amount available which you do not borrow against.

So, if you have a $200,000 HECM LOC at 5% interest and only use $30,000 in the first year, then you would have $178,500 available to draw against the next year, or $170,000 plus 5%.

Why is this good?

First, by delaying tapping into your retirement funds, you’re giving them time to grow. This is particularly important if you start off your retirement in a down market. Instead of zapping your funds’ ability to recover, you’re keeping your money invested in the market, so that when the market recovers, you’ve not created a situation where you have to gain incrementally more to be back at the level where you were.

Secondly, if you have an older house, you could be in a situation where you are able to pull more equity out of the house than the house is worth. Let’s look at how an untapped HECM LOC could grow, assuming the same $200,000 LOC at 5% interest:

Year LOC Value
1 $  210,000.00
2 $  220,500.00
3 $  231,525.00
4 $  243,101.25
5 $  255,256.31
6 $  268,019.13
7 $  281,420.09
8 $  295,491.09
9 $  310,265.64
10 $  325,778.92

Most HECM Saver LOCs are limited, in origination, to about 55% of the total value of the house, so it would take a while for the line of credit value to exceed the value of the house, but, particularly if the house is older, it’s quite possible to do so.

Here’s a set of instances where they’re something you should look at incorporating into your financial plan:

  • You don’t have quite enough saved up to live on. This is the obvious one. If you’re going to be just a touch short of where you need to be with your savings and investments, then a HECM accomplishes two goals for you:
    • Buys time for your retirement fund to grow.
    • Shortens the lifespan you’ll require the nest egg to support you.
  • You’re retiring in a declining stock market. Almost every retiree who faced running out of money before running out of heartbeats did so when the first few years of retirement decimated their retirement portfolio. If the market is down, you don’t want to be withdrawing from your retirement funds, so the HECM LOC makes a great “retirement emergency fund” for you to tap into while giving the market time to recover.
  • You have enough in assets, enough income stream, or enough long-term care insurance to cover assisted living, a nursing home, or other long-term care arrangements. There’s no point in tapping into your home equity and depleting it if you’re going to wind up in dire straits if your health declines and you need assistance for the activities of daily living (ADLs – another government acronym!). If you plan on leaving your home feet first, you can probably ignore this one, as you’d get home nursing and hospice care.
  • Your house is going to depreciate in real value over time. We’ve recently seen that real estate doesn’t always go up. M.I.T. professor and Nobel Prize economist Robert Shiller recently stated that the inflation-adjusted return of real estate is close to 0%, and not everybody is average, so there’s a decent possibility your house will decline in real value over time. Getting a HECM LOC on a house which will go down in value over time is a perfect example of selling a liability.

Strategic use of a HEMC LOC can delay both the drawdown of assets in your other accounts and the time when you’re forced to purchase an annuity to create income. Both of these options have significant value if you don’t have a big margin of error in the amount of assets you have compared to the amount of assets you need to meet your expenses without running out of money.

These two articles, like the budgeting articles “Cracking the Whip on Your Money” and “Money Comes and Money Goes”, are not one-and-done articles. You should, once a year, review these two articles to make sure that you’re on track for your retirement savings. While you probably won’t need to make significant adjustments to your savings strategies, it helps to see where you are at, and going through these articles annually will allow you to make course corrections earlier to prevent you from having to save significantly increasing chunks of money just a few years before your retirement.

There’s one final piece to the retirement puzzle – Social Security. While many people claim that they don’t expect to receive Social Security, I’d be surprised if all but the youngest generations currently around don’t get a significant chunk of what they should receive, even if it’s delayed by a few years later than current generations receive it. You can plan as if you won’t receive any Social Security, and the worksheets allow for that planning, but for those who aren’t so young that Social Security seems like a pipe dream, we need to look at strategies for deciding when to take Social Security. We’ll examine these Social Security strategies in a future article.

Related articles:

Maybe You Don’t Need Bonds in Retirement: An Interview With Dr. Wade Pfau, CFA

Reversing My Stand Against Reverse Mortgages

 

[1] All returns include reinvesting dividends and capital gains.

[2] http://www.moneychimp.com/features/market_cagr.htm

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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