If you ever contemplated retirement, you certainly have asked yourself this question: “How much money do I need in my nest egg in order to be able to quit working and have my financial needs met?”  Is a million dollars enough?  Or do you need two million or more?  As you might have suspected there is no magic number that fits everyone’s needs.  There are many sophisticated tools and models that you can use in an attempt to answer this question, and any financial advisor that is worth his weight should be able to provide you with some interesting tools.

However, no matter how sophisticated a tool you use, all the tools have one common caveat – they are all based on assumptions.  At a minimum you will need to make assumptions about how much money you will spend during your retirement years, about the rate of inflation and about how much return you expect to get on your investments.  But if there is one thing we all know about assumptions, it is this:  they rarely match reality. 

So if you think that by using a very sophisticated tool or complex model that you will be guaranteed  a more accurate assessment of how much money you will need to retire, think again.  If your assumptions are bad, the output from your sophisticated tool will be bad.  You would be much better off with a simple tool and a good set of assumptions.  Even a very simple tool can do a relatively good job in predicting how much you need to save for retirement if the assumptions are good.

In this article we will make a number of assumptions and use a very simple tool to try to come up with a suggested range of how much money you need to save in order to be ready for retirement.  So let’s get to work.

For both the low end and the high end values we will assume that you will not try to use up all your savings by the time you pass away, that is, the investment amount will remain constant and will be passed on to your heirs.  This is a more conservative assumption, but it removes the variable of having to guess your life span.

The Low End

To come up with a low end figure for our range we will make the following assumptions: You will have modest expenses during retirement and will be able to live comfortably with $50,000 per year, including taxes; inflation will be stable and low, around 3%; you will achieve a relatively high rate of return on your diversified investment portfolio, averaging 9% per year.  In summary:

Total expenses per year, including taxes (A): $50,000 per year

Average rate of inflation per year (Y): 3%

Average rate of return on your diversified investment portfolio(X): 9%

Using the simple formula A/(X-Y) we can calculate the approximate required savings for your retirement as $833,000.

The High End

To come up with the high end figure for our range we will make some different assumptions: You will have relatively high expenses during retirement, but will not live an extravagant lifestyle, requiring $100,000 per year including taxes; inflation will be a bit higher, averaging 4% per year; the average return on your conservative portfolio will be 7% per year.   In summary:

Total expenses per year, including taxes: $100,000 per year

Average rate of inflation per year: 4%

Average rate of return on your diversified investment portfolio: 7%

Using the same formula we used before, we can calculate the approximate required savings for your retirement as $3,333,000.

As you can see, even a relatively small variation in assumptions can have a huge impact in the amount of money you will need to save for retirement.  You can play with the assumptions above and come up with an amount that you feel comfortable with.  But keep in mind that most people underestimate their expense needs and overestimate the expected return on their investment after inflation, so it is advisable to be conservative.

What amounts would we recommend you use for your assumptions?  On the expense side, look at your historical spend, and make some adjustments for your retirement needs.  For example, if you plan on having your house paid for by the time you retire, you can remove the mortgage expenses, but keep the property taxes; remember that you may have additional health care costs as you get older, so increase your estimates for health care; and so on and so forth.  For your investments, a good yardstick could be the average return you have been able to achieve in the last ten years, plus some level of adjustment for what will likely be a more conservative portfolio.  As for inflation, if you choose a value around 3-4% you will probably be in the ballpark as a reasonable average of a period of several years.   

Figuring out how much you will need to save in order to retire comfortably is as much of an art as it is a science.  The more conservative your assumptions, the less risk you face of running out of money in retirement.  But if you are too conservative, you may find yourself working a lot longer than you are comfortable with.  The trick is finding the right balance.