COMMENTARY | A recent MSN Money article by Karen Blumenthal of The Wall Street Journal discussed an interesting concept. It was actually a concept developed by Fidelity Investments, and it reviews a financial planning theory for retirement that I found interesting. The article considers a question many of us have probably pondered at one time or another when contemplating retirement. Wouldn't be nice to have a simple rule of thumb for a savings number to aim for in retirement planning?
It goes on to answer that question by way of the following: "In September, Fidelity Investments, the nation's largest provider of 401k plans, tried to do just that, offering up a magic number: eight. Typical wage earners, Fidelity said, should aim to save at least eight times their final annual pay to be sure they can afford basic living expenses in retirement."
This number could work out for our family's situation...but there's a catch.
A Salary Example
While my wife and I still have a ways to go until retirement (we're talking at least 30 years), I can take an estimated guess at what our retirement salary could be by the time we retire. I don't want to shoot too low, because that will skew our numbers, but I don't want to estimate too high either, since that could lead to complacency in our current savings and shortfalls come retirement time. Therefore, I prefer to take a lower-range number of $75,000 a year combined annual income for us the last year before we retire. I certainly hope that it's more than that come 30 years from now, but I prefer to err on the side of caution when it comes to our retirement planning.
Using the Fidelity example, we would need 8 times this amount -- or $600,000 -- to live comfortably in retirement.
Cost Inflation
Right now, we keep our costs reasonably low. Our annual family expenses currently run right around $30,000, which includes costs for employer-sponsored health insurance, taxes, and pretty much all other expenses across the board. Taking this amount, and fast-forwarding 30 years, factoring in cost-of-living increases of 3 percent a year, and we're looking at annual costs of about $73,000 a year. While hopefully, expenses related to income tax and work expenses will be minimized at that point, they could be negated by the increased costs of things like health care and medical expenses.
Additional Sources of Income
If our $600,000 nest egg could earn an annual return of 6 percent (which isn't out of the question since the low-risk income fund my current retirement plan is in provides around this amount in dividend reinvestment each year), this would provide $36,000 of our necessary retirement income. While it's almost impossible to predict what, if anything Social Security will provide in retirement, even in reduced benefits, let's say it provides my wife and I an extra $20,000 a year. And since I plan to continue working part-time in retirement, let's say I can earn an additional $15,000 a year in supplemental income. These income totals would take us to $71,000 a year, which is just $2,000 off our expense estimate. This means that we would need to make up the $2,000 difference through drawing off our retirement fund total, which would slowly eat away at its core balance and potential returns, but not at a substantial rate.
The Problem
The problem I have with Fidelity's "8" factor, is that retirement can come with a variety of unexpected and often costly issues. From health problems issues to economic or stock market issues, there are things that could take a big chunk out of our retirement fund balance. Looking back to the financial crisis when my retirement account lost about 40 percent of its value, I hate to think of such a scenario occurring in retirement when I would be counting on that money as a source of income.
Let's say that once we retire, the stock market again plunges 40 percent. Well, that $600,000 that we would need in our retirement savings would suddenly become $360,000 and our rate of return on this amount at 6 percent would become $21,600 instead of $36,000. This would mean that instead of drawing down just $2,000 a year from our retirement balance total, we would instead be drawing down over $16,000, eating away at our already diminished account total much quicker, which in turn would act to diminish our returns off this investment further each following year.
Therefore, while I think the Fidelity number is certainly a good start for people to begin evaluating their retirement future and setting goals, it may not be exactly the number for everyone.
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