How much do you need to save to retire? Check the risk free ROR
Today lets go over a simple concept that doesn't get enough mental attention. That concept is: how much money do you need to save to retire? There are a couple ways to break down that question let's look at them here:
- How much money do you need to spend every year when you don't work?
- How much money do you need saved in order to create an income equal to your living requirements?
Naturally, the answer to each one of these questions is non-trivial and a bit involved. For the purpose of our article today we will be focusing on #2 above. For our example we will use throughout the article, we will also assume that your answer to #1 above is 50k a year. That is to say, you feel you have thought through everything and come to the conclusion that you could survive happily for the rest of your life on an average of 50k dollars a year in income.
Some assumptions we will even have to make to simplify this even further are as follows:
- None of the income you receive in your retirement will be from you actively working.
- The income will be created from passive investments which do not require active maintenance. IE no rental property will be considered here.
- These investments do not need to take into account inflation. We can assume you have taken this into account when calculating your income requirement.
Now back to the main issue at hand. How much money do we need to save then to create 50,000$ every year? There is a sliding scale that can answer this question. On one end, we have a risk free investment and on the other hand we have higher risk investments. For the low end of the spectrum we can use the 10 year treasury bond yield like everybody does and it looks something like this in 2017:
So assuming we are working in the present, the risk free rate can be surmised as 2.19%. To create 50,000$ every year at 2.19% interest on a given balance, that balance will need to be 2,283,105$. Calculated using this formula below with our example numbers populated in
Principal=(income)/(Risk free rate)= 50,000$/.0219=2,283,105$
Well now we know why so many people are in trouble. Retirement savings for the oldest group of 56-61yr old Americans is less than 1/10th that value! Another thing to consider here is that this number does not include inflation, and for the purposes of this article here we will need to assume you have taken this into account in your expense requirement of 50k, otherwise this gets a lot more complicated.
I got this graph and idea for the article from Financial Samurai's article here. And of course if you are reading this site, you likely do not have 2 million dollars invested somewhere and still looking for advice. Why do you think that is? Well because the average multi millionaire likely knows more about finances than to settle for the risk free rate of return at 2.19%. In fact on average I bet they do well over 5% a year with ease and low risk. Here comes that sticky issue which can't be avoided when you talk about returns on investment: RISK. Basically, the more risk you are allowed to have, the more return on your investment you can expect. The graph looks something like this:
This topic is outlined here on Investopedia if you want to read about it more. Now I know for a fact that 2.19% percent is not a good rate of return. The stock market on average returns 7% a year after adjusting for inflation, which is more like 12% return when we do not account for inflation which we are purposefully not doing, remember? Using the above formula, you can come to the result that with 12% rate of return, you can make 50k a year with a principal balance of only 416,666$. Here is a graph I made to show what we are talking about in this specific example:
Well now you know how much money you need to save and how much risk to expect when utilizing completely passive investments for retirement. This article should stress the importance of saving, because even at the low end of the required scale 400k is not to be scoffed at. This article also outlines the basic idea that your side hustle is almost more important than savings, because passive investment income is very, very, expensive. For instance if you could generate just 25k on a side hustle that you enjoy and could do while retired, that would enable you to retire with half of the savings normally needed and that might be significantly sooner!