What's Your Magic Number: Figuring out How Much Money You Need for Retirement (Secret 8)

How much money do you need to retire? A hundred grand? A half-million? Ten million? I'm getting ahead of myself. Have you even tried to calculate how much money you'll need to retire? Chances are you haven't. The Employee Benefit Research Institute reports that 56% of workers haven't made an effort to figure it out. Maybe that's why statistics show nearly 75% of retirees haven't saved enough and say they would save more if they could do it all over again. How much money do you need, then? In his book The Number, former Esquire editor-in-chief Lee Eisenberg talks about why "the number" is so important. He says that, for most people, it represents a free pass to a great life without financial stress. That's what it always meant to me. When I was in my 30s, I had a number in mind. It was a net-worth number. I was determined to achieve it in fewer than 10 years. And I did. But after retiring, I quickly discovered I was using the wrong number. Net worth matters, but it is not "the number" you need to plan your retirement. Your net worth includes all assets - including your house and your favourite "toys" - which you may not be willing to give up in retirement. That's what happened to me. I wasn't psychologically able to move into a smaller house, get rid of my little fleet of vintage cars, desist from buying fine art, etc. It was a big lesson. Your Magic Number is how much you need to replace your active income and pay for your expenses... after you've quit your 9-5 job. Because I used the wrong number, I had to go back to work. I picked a new number, a real number, and worked another 10 years to hit it. When that day arrived, I felt fantastic. I also changed my priorities. Making money was no longer my No. 1 goal. I could spend more time on hobbies - some of which were businesses (such as my art gallery and my film production company) that had little chance of making serious money. This is a good feeling, one I can recommend to you. If you haven't had that feeling yet, I hope that what I'm about to tell you will put you on the right track... Most people fail to achieve their retirement dreams, Eisenberg says, because they make two mistakes: Many people enter their 40s and 50s "ensconced in a cloud of avoidance and denial about the years ahead of them." They spend their early years not doing any serious retirement planning. "They sense they are far behind from where they should be, but they don't want to face the truth. These are the procrastinators," Eisenberg says. Other people do retirement planning, but they're sloppy about it. They don't know how to calculate their Magic Numbers correctly, so they pick arbitrary numbers and hope for the best. Eisenberg calls these people "pluckers" because they pluck numbers out of nowhere. You don't have to make these mistakes. They are actually easy to avoid. Let's do that now. Let's figure out how much money you have to save in order to quit work and enjoy retirement fully. I call this your "Magic Number." A Lesson Learned From Retirement No. 1 I retired for the first time when I was 39. I had a net worth of about $10 million, half of which was liquid. I thought I had all the money I would ever need. As it turned out, my retirement lifestyle was more expensive than the one I described above. I liked first-class travel, five-star hotels, and fancy cars. My yearly net was close to $500,000 - after taxes. To generate $500,000 in after-tax dollars, I would have had to earn $900,000 in passive-interest income on that $5 million. That represents a return of 18%. I understood enough about stock market performance to know that was impossible. I should have cut my expenses drastically. But I didn't want to. I enjoyed the lifestyle I had. I was still a big spender. So I had no choice. I had to go back to work! I put the word out and got a few offers. A month later, I was back at work. I half expected to feel miserable, toiling away again. But the moment I started earning money again, I started to feel better. Five Steps to Finding Your Magic Number I am going to give you five calculations. Each one should take just a few minutes. The entire process, including all five steps, should take no more than a half-hour. Please do it now. In terms of your future wealth and happiness, it may be the most fruitful 30 minutes you ever spend. Step 1 - Calculate How Much Money Your Current Lifestyle Requires The first step is to calculate your Lifestyle Burn Rate (LBR). This is the amount of money needed each year to enjoy your lifestyle. It's easy to determine this number. Simply calculate how much you are currently spending to live life each year. I find it helps to group the expenses into five categories: housing (including maintenance and taxes), basic living expenses (food, clothing, health care, etc.), education (if applicable), entertainment (including travel), and charity (if you believe in it). This exercise may be illuminating. (When I redid it recently, I was shocked to find how much money I'm spending on cigars - $14,000!) You may find this exercise alters your idea of a quality life. (I'm cutting back to one per day.) It will also make it easier to make adjustments in the future, if your lifestyle changes (see sidebar below). Don't guess at these numbers. Guessing, in my experience, correlates with grossly underestimating. Use your actual costs from the past year. Your LBR is a critical number. Without it, you can't make any other financial planning calculations - such as how much money you need to save for retirement. And that's our next step. The Three Stages of Your Financial Life  Your Lifestyle Burn Rate (LBR) is likely to change three times. The first stage is up until you have your first child. The second stage begins when you have your first child and continues until your children are gone and their college expenses (if you are paying them) taken care of. The third stage begins after you are free and clear of dependencies, and it continues until you pass away. For most people, the first stage has the lowest lifestyle burn rate. You are young and relatively unburdened. If you are wise, you will limit your expenses to necessities and drink cheap liquor. The second stage, typically, has the highest lifestyle burn rate. You have larger home expenses, bigger basic living and entertainment expenses, and educational expenses for your children. For some people, this stage extends in time if you're required to provide for aging family members. The third stage has a LBR that will likely be twice that of the first stage, but significantly less than the second stage. This is - or can be - a wonderful part of your life during which you can enjoy traveling, hobbies, and entertainment without working more than you want to. To complete this exercise, you'll need to calculate your LBR for your current stage and for stages you haven't completed. If you are in stage one, you'll need to figure out your current LBR and estimate it for the second and third stages as well. Step 2 - Adjust Your LBR to Account for Any Changes in Spending Patterns That Will Be a Part of Your Retirement Lifestyle The next step is the one most people start with: deciding how much money you'll be spending each year in your retirement to enjoy the lifestyle you want. I just told you how to calculate your Lifestyle Burn Rate (LBR). What you are doing now is figuring out your Retirement Lifestyle Burn Rate (RLBR). Take your current LBR, the one you just figured out above. Now add to it any "extras" you want to enjoy during retirement and remove any expenses you won't have in retirement. Let's say, for example, that your current lifestyle burn rate is Rs 80,000 per month. To make your retirement more fun, you want to own an extra car - a sports car - and join a golf club. This will cost you an extra Rs 10,000 per month. Add Rs 10,000 to the Rs 80,000 and you have Rs 90,000. Or maybe you plan to travel Europe. Or you want to help finance a grandchild's education. Regardless of what it is, here's where you add in those anticipated costs. Now subtract from that total number (in this example, Rs 90,000) any expenses that you currently have but will no longer have when you are retired. This commonly includes expenses for your children and other expenses related to having a family with children. For example, if those expenses are currently Rs 15,000, you will deduct that from the Rs 90,000. That would leave you with Rs 75,000 per month, or 75,000 x 12 = Rs 900,000. Got it? Step 3 - Adjust Your RLBR to Account for Any Additional Sources of Income The next step is to take your RLBR and subtract from it any income you are confident you'll receive during your retirement. This income could include a company pension, or side-business income. Subtract that from your RLBR. You can do the same with any pension income you expect. And finally, if you intend to work part-time during retirement, you can deduct that, too. Let's get back to the example. Let's say you just calculated your RLBR and found you'll need Rs 75,000 per month. To make these new calculations, you would deduct, say, Rs 10,000 per month you expect to get from some pension. And finally, you'd knock off another Rs 15,000 per month you expect to get by working as a consultant two days per week. This reduces your RLBR from Rs 75,000 to Rs 50,000. Which, multiplied by 12 months, equals Rs 6 lac per year. This is your Net Retirement Lifestyle Burn Rate (NRLBR). It's an important number. Step 4 - Determine What Rate of Return You Expect to Get on Your Savings You've just gone through the steps to calculate your Net Retirement Lifestyle Burn Rate. In our example, that amounts to Rs 600,000 per year. This is the amount needed to live the retirement you want. There's one last thing we must know before figuring out your Magic Number. It's the rate of return you can expect to get on your retirement savings. For instance, if you expect to get only 10% on your money, then your Magic Number - the amount you'd need to save before retiring - would be Rs 6,000,000 at 10% to generate Rs 600,000 in annual income. So what rate of return should you plug into this equation? That depends on what kind of investments you use. Most financial planners will spread your money into an assortment of stocks, bonds, and cash. But I don't like the idea of having my retirement fund in just stocks and bonds because the market can fluctuate greatly from year to year. A better choice would be to follow the asset allocation model we've designed for readers. Asset allocation is the process of dividing one's wealth into different asset types such as stocks, bonds, real estate, gold, and cash. The asset classes we recommend are real estate, stocks, bonds, gold, cash, and income. With the asset allocation model we suggest, you can expect to earn a 12% return each year. You should update this expected return each year depending on market conditions. But for simplicity's sake, let's look at a basic example. Let's say you own investments in only stocks and bonds. And let's say you weighted your investments equally in each class. It would be reasonable to expect the following returns on those asset classes (after taxes): Stocks: 15% Bonds: 9% If you have equal amounts invested in each asset class, that means your total expected after-tax rate of return would be 12% (the average of both the asset classes). You now know how much money you need to earn annually to enjoy your retirement. And you know the rate of return expected from your lump sum of allocated investments. That means you have the tools to calculate your Magic Number. Step 5 - Calculate Your Magic Number To figure out your Magic Number, start with your NRLBR. In our running example, that was Rs 600,000. Now, divide it by the expected rate of return you just calculated. Using the same example, you would divide the Rs 600,000 (NRLBR) by the expected rate of return, 12%. Six lac rupees divided by 12% (0.12) is Rs 5,000,000. That is your Magic Number! If you had this amount of money invested right now making 12% each year, you could retire. Get it? Just divide the income you will need in retirement by your after-tax expected interest rate. In case you are lost, let me break it down for you again, using the original example. The following is just an approximation... Check your bank ledger and credit card statements and figure out how much you spend (this is your LBR). In our example, this is Rs 80,000. Adjust your LBR for how much money you'll need to spend during retirement to provide the type of lifestyle you want (this is your Retirement Lifestyle Burn Rate, or RLBR). This gives you Rs 75,000. Adjust your RLBR lower to account for any income you expect to receive during retirement. This gives you a Net Retirement Lifestyle Burn Rate of Rs 50,000 x 12, which is Rs 600,000. Determine the after-tax rate of return of all your investments combined that you can expect to receive on the money you have invested. In our example, that is 12%. Calculate your Magic Number by dividing your NRLBR by your rate of return. Rs 600,000 divided by 0.12 = Rs 5,000,000. Congratulations. You just figured out exactly how much money you need in order to retire. Write it down on a sticky note. Put it on your office desk or file cabinet. Always keep this number. The magic number you need to hit. How Does Inflation Affect Your Magic Number?  Unfortunately, thanks to our wonderfully messy Indian economy, we have to account for the money-eating monster that is inflation. When planning for your retirement, you have to consider the effects of inflation on the value of your portfolio. That's because, in most cases, inflation makes future ruppes less valuable than they are today. The Rs 80,000 per month we've been using in this essay, for example, will still be Rs 80,000 in 10, 20, or 30 years... but it will buy fewer things than it can buy today. [Inflation is the rate at which the general level of prices for goods and services rise each year. For example, if inflation were 8%, the loaf of bread that cost you Rs 10 last year would cost Rs 10.08 this year. Its price went up... and because it went up, you'll end up buying less bread this year.]  So how do you account for inflation in your Magic Number planning? One way is by owning businesses that keep pace with inflation. Companies like this raise their prices to match inflation. Many of the stocks we recommend in our portfolio are of that kind. Having 20% of your portfolio in such stocks will help. But the main inflation hedge you have in the portfolio I recommended is the real estate portfolio. Real estate, as a tangible asset, appreciates during inflationary times. More importantly, if you rent, as a landlord, you should be able to increase your rent to match inflation. These factors should go a long way toward protecting the validity of your Magic Number. But if you want to be extra sure, you can simply use a smaller interest rate to calculate your Magic Number. In our existing example, we're dividing Rs 600,000 by a 12% interest rate. This gives us a Magic Number of Rs 5,000,000. But to be more conservative, you could lower your interest rate to 4% (0.04). This would increase your magic number to Rs 15,000,000. If you have 20, 30, or 40 years to go before retirement, you might want to use this more conservative interest rate. Your Personal Retirement Diagnostic: How Close Are You to Reaching Your Magic Number? In "What's Your Magic Number?" above, I gave you step-by-step instructions for how to calculate your Magic Number. Remember, your Magic Number is the amount of money you need to have saved and invested in order to quit work and enjoy retirement. In other words, a lump sum of money that can provide interest income to live off of. Today, we're going to take the next step: We're going to run a personal financial diagnostic. I'm going to walk you through a check-up to determine exactly how close you are to reaching your Magic Number. I'm going to show you two ways to analyse how far along you are toward achieving your goal. Using the first way, I'll show you how long it will take you to reach your Magic Number if you keep saving money at your current rate. Using the second way, I'll show you how much money you must begin saving each year in order to reach your Magic Number by a specific future point in time. Let's get started. Step 1: Calculate How Much Money You Have Already Saved Write down how much money you have already saved toward retirement. This should include liquid assets (i.e., cash, stocks, mutual funds, and bonds in fixed deposits, and qualified plan accounts or things such as gold). It should also include any illiquid assets (i.e., an auto collection, a rare piece of art, or a second home) that you plan to sell prior to retiring. If you live in a large house now but plan to live in a less expensive house in your retirement years, add expected profits from the sale into your retirement savings. But be conservative. For example, if the house you live in now is worth Rs 2,000,000 and you will be happy in a smaller house that will be Rs 1,000,000 cheaper, add Rs 1,000,000 to your retirement savings. Do this right now. Figure out exactly how much money you have in retirement investments/savings today. Step 2: Compare This Number to Your Magic Number Let's say you just added up all the money you have saved and invested and it amounts to Rs 2,500,000. Our next step is to compare this to your own personal Magic Number, which I showed you how to calculate in the previous essay. In our example from that essay, we discovered that our Magic Number was Rs 5,000,000. So now we take that Magic Number and subtract from it the amount we have currently saved and invested. Rs 5,000,000 - Rs 2,500,000 = Rs 2,500,000 We now know that we have to save an additional Rs 2,500,000 before we're able to hit our Magic Number and retire. It's here that we come to a decision point. You have two options: You can calculate how long it will take you to save this much and reach your Magic Number at the current rate you're saving. Or you could calculate how much money you'd be required to save each year if your goal was to retire at a specific time in the future. Let's calculate both, because each is useful. Step 3: Calculate How Long Till You Hit Your Magic Number at Your Current Savings Rate  To do this, we look at how much money you're saving each year. These savings can come from money you set aside from your paycheck. Or it can come from dividends you receive from stocks or other investments... maybe both. Whatever the source is, it all funnels to the same place: your retirement savings account. For this example, let's say you're able to save Rs 250,000 per year from your paycheck and stock dividends. Now we simply divide that Rs 2,500,000 (the amount we still need to save) by Rs 250,000. This means that, at your current savings rate, it will take you nearly 10 more years to retire. Is this good or bad? Well, it depends on your age. If you're in your early 50s and had planned to retire at 65, you're in great shape. But if you're 58 and had wanted to retire at 65, this reveals that your goal isn't realistic at your current savings rate. Let's say you just crunched these numbers and you've discovered you're not saving enough to retire at 65. You'd probably want to know, "Well, how much would I need to be saving to make retirement at 65 a reality?" That leads us to the second way you can analyse how to reach your Magic Number. Should You Include Capital Gains in Your Calculations? In Step 2, you compared how much money you've already saved toward retirement to your Magic Number. Whatever the difference is will be how much money you must save before you can reach your Magic Number and retire. I said you'll need to accumulate this amount of money through savings from your paycheck or stock dividends. You might have noticed I didn't suggest you should include any capital gains from your invested "savings" (for instance, if you're investing your savings in a basket of safe stocks that are gaining value at 12% per year). I did this to make things simpler. You could choose to include forecasted gains from your investments. And if you do this, it will shorten the expected time it takes you to reach your Magic Number. But I don't recommend this. That's because not including these gains will give you an extra cushion. Unforeseen expenses will certainly arise that will eat into your savings. Not including these gains in your calculations gives you more breathing room. Also, these are unrealized gains. That means they're not certain. Therefore, if your projection is wrong, it will distort the accuracy of when you reach your Magic Number. But if you decide that you want to include expected capital gains anyway, at least be conservative Step 4: Calculate How Much More Money You Must Save in Order to Retire at a Desired Time You're 58 years old. You need Rs 2,500,000 more to retire. You want to retire at age 65. How much do you need to be saving each year to reach your goal by age 65? It's simple. First, calculate how many more years you have until you want to retire. In this case, that's seven (65 - 58). Then you just divide how much more money you need to save by seven. In this case, that's Rs 2,500,000 / 7 = Rs 357,000. Is this realistic or not? Well, compare it to your current savings rate. That means either you'll need to push your retirement date further back, or you'll need to find a way to begin saving an extra Rs 1 lac per year. Regardless of what you decide, going through this diagnostic process will tell you exactly where you are on your retirement journey, and how to get where you want to be. Be Sure to Give Yourself an Annual Check-up Doing all these calculations just one time won't cut it. The inputs are going to change over the coming months and years. Your income could change (a new job or promotion). And that means your retirement road map will change too. For instance, what happens if your 16-year-old daughter gets her driver's license... and proceeds to have an accident that totals your car? What happens if your spouse's deceased great-aunt leaves you an unexpected Rs 1,000,000? What happens if some of your investments turn south and your expected rate of return drops by half? Unforeseen events that affect your finances are going to happen. And those events will alter your retirement plan. That's why you should make this an annual check-up. The Employee Benefit Research Institute recently conducted a study. It measured how confident people feel that they have enough money to retire comfortably. The conclusion? The numbers came in at the lowest level ever in the study's 23-year history. This issue probably extends beyond one country. But we are not counting you among those people. You now have the tools to take control of your retirement planning. To summarize, first, calculate your Magic Number. Then, calculate how close or far off you are from achieving it. Then, make the decisions to earn more money or delay your retirement goals. I hope you take the time to get started right now. By Mark Ford