Which number? The one that means financial independence for you. How much money would you need to have saved in order to be able to give up working for pay whenever you want? Most people don’t know. The book, The Number, by Lee Eisenberg was good for helping readers understand the variety of ideas and issues that go into determining any one person’s number. How long do you want to work? What do you want to spend your time doing when you stop working? Will you work part-time? How long will your money have to last? These are all important questions, but fall into the category of fine tuning. The fact is that most people aren’t saving anywhere near enough, and worrying about the answers to these questions, get’s in the way of getting started.
There is a simple way to get to a number that is in the neighborhood, and you can worry about answering those fine tuning questions once you’re in the rhythm of saving. Start with how much you are spending. Most people don’t actually know this either. I told my husband Jeff how much we were spending several years ago, and he didn’t believe me. No you don’t have to track every dollar that goes out the door for months to figure out at a high level how much you are spending. Here is what you can do.
- Pull out your tax return, which will show you your gross income and how much you paid in taxes.
- Pull out the statements for the accounts where you saved money. These would be your 401(k) accounts, IRAs, and other personal savings accounts. Find you deposits for the year.
- Subtract number 2 from number 1, and, voila, that is what you are spending. If you didn’t save it or pay it out in taxes, you must have spent it.
This is the spending amount I used to come up with our number. Now, if you’re like Jeff, and you can’t figure out where all that money is going, then you have to track you’re spending. To me, it didn’t matter what we were spending the money on. I just knew that I didn’t want our life style to change once we stopped working, so my goal was to be able to withdraw what we were spending annually and have our savings last a very long time. How long is a long time? Well let’s just say you don’t want to have to go back to work at the age of 85 because you ran out of money! I personally am planning to live to be 125 (or maybe that’s until I feel like I’m 125).
The next step in figuring out your number is to find out how much you will get from sources that are not your personal savings. One obvious source is Social Security. Another source could be a traditional pension (which provides monthly payments in retirement based on your years of service and annual earnings your last few years of work). However, few companies still provide these, unfortunately. Monthly payments under these programs are relatively easy to estimate on the Social Security web site, or by asking your employer. Subtract these sources of income from what you are spending annually, and you will have the annual income that has to be supported by your personal savings. Multiply this number by years your money has to last, such as 25 years, and you will have a ball park estimate of your number. The 25 years number just so happens to also correspond with the rule of thumb that you can spend up to 4% of savings and have your savings last, which was proposed by William Bengen in The Journal of Financial Planning in 1994.
If you do this exercise, you may be shocked at the size of the number. You may find that in order to accumulate what you need, you have to save substantially more than you are saving today. Truly tragically, no one tells us how much we’ll realistically need to save to have a secure retirement. When I was working on our number we already had a sizeable nest egg, and we were on track for meeting our savings goals. Jeff and I have always been savers. One advantage of being a saver, beyond the obvious growth of your nest egg, is that the spending level that needs to be replaced when you stop working for money is lower, which ultimately makes your number lower. Here are a few ways to begin to make headway toward your new savings target.
- Make your savings goal a budget item, like rent or utilities, and make sure that gets paid before any discretionary spending.
- Use windfalls and pay increases to increase your savings. If your employer pays a bonus put it directly in savings. If you get a raise, use the increase to up your retirement plan contributions.
- Take a hard look at your lifestyle. If you have not saved enough to date, you are living beyond your means. Where could you change? Perhaps a cheaper car, smaller home or less expensive city needs to be considered.
Look at it this way. You can reduce your spending in order to save more today, or you can reduce your spending later when you stop working because you didn’t save more today. The sooner you start, the smaller the bite out of your lifestyle, and the more control you will have over the outcome. Save early and save often, and financial independence can be yours!