4 steps to calculate how much you need to retire

Morningstar is a firm believer that a goals-based investment approach is the best way for investors to achieve their objectives.

Understanding what you are trying to achieve is a critical step in designing an investment strategy. It also allows you to track progress towards your goal and course correct as needed.

Retirement planning presents a particular challenge as many investors struggle to figure out a dollar amount at retirement that can generate a sustainable annual withdrawal to pay for living expenses.

This step-by-step guide can be used by investors of any age to estimate the size of a retirement portfolio. You can also watch the webinar below for a real-time example.

4-step process to estimate spending needs in retirement

Over the course of your working life you are conditioned to think of day-to-day spending in terms of a set salary. And this is a good place to start with retirement planning. In retirement your ‘salary’ will come from your portfolio instead of from an employer.

A good starting point is using your current salary to determine what you need to replicate your current standard of living. This is especially pertinent for people approaching retirement but also works for younger investors as we can adjust your current standard of living into the future.

Step 1: Tax and savings adjustments

There are two initial adjustments that we can make to your salary when trying to determine what it will take to maintain your standard of living in retirement.

The first is the taxes you pay. For most investors that will be accessing superannuation to pay for retirement we can eliminate taxes. In the pension phase of superannuation withdrawals will not be taxed if you meet the age requirements.

The next adjustment to make is to remove the amount of your salary you are saving. At the very least we can remove the 10.5% of your salary that represents the mandatory super contribution. For some investors the savings rate will be higher given additional contributions to super or savings outside of super.

To do this you can simply look at a pay slip and annualise the amount you pay in taxes and super contributions or use a tool like paycalculator.com.au.

Below is an example of a $100,000 salary.

Assuming that you will pay no taxes for retirement withdrawals and will no longer be saving means that you can remove $9,090 in super contributions and $20,777 in taxes.

In retirement $70,130 will allow you to maintain your current standard of living from a $100,000 salary.

Step 2: Lifestyle adjustments

The next set of adjustments are for lifestyle changes in retirement.

This involves some thought about what you will do in retirement. If you are moving to a cheaper location to retire now is the opportunity to adjust your spending needs downward.

If there are major changes that you anticipate in retirement like having paid off your house, you can remove mortgage payments from your spending needs.

It is also worth contemplating how your spending needs may shift in retirement. Many retirees initially spend more money. The freedom of not being tied down by a job may mean more travel or higher day-to-day spending given the additional time for activities.

Step 3: Taking salary inflation into account

This step can be skipped if you are approaching retirement. Inflation adjustments post-retirement are included in the selection of a safe withdrawal rate.

For investors that have a longer time horizon until retirement we need to make adjustments for cost of living increases and the natural lifestyle creep that generally occurs as we age.

The inflation adjustment represents the erosion of purchasing power over time. This adjustment does not represent an increase in your standard of living. It is simply the increase in spending needed to maintain your current standards.

Select the inflation percentage you expect annually until your retirement. Inflation does tend to bounce around and we are going through a period of high inflation right now. However, we simply need the average annual increase until you retire.

Morningstar expects inflation to average 2.8% annually over the long-term.

Another adjustment can be made if you believe your salary and lifestyle expectations will grow faster than inflation over time. As we age and gain work experience and additional credentials our salary may grow faster than inflation.

This can be done in two ways. You could come up with a percentage increase over inflation for the rest of your working career or a lump sum in a dollar amount that you believe your salary will go up. The lump sum approach may work better if you have more visibility into your career pathway and the extra earnings that would entail.

A word of caution for this adjustment. At some point all of us reach a limit in salary. This may come as we naturally hit the ceiling of our ability and/or desire to keep moving up in our careers. For a select few this may come as we reach the pinnacles or our profession but for most it happens well before that.

Even a small percentage increase over inflation builds up if we have a long time until retirement. If you are fortunate enough to continue to significantly and continually increase your salary over time you can always adjust your estimate in the future.

Another reason to be conservative in the estimate is that we are projecting after tax salary. Graduated marginal tax rates mean that as you earn more your after-tax salary rises at decelerating rates.

Once you have a percentage increase of your salary over time you can use an online calculator to estimate your salary at retirement. For a lump sum simply increase your current salary and use inflation estimates for future growth. For percentage increases add the above inflation growth to your inflation estimate.

Morningstar Investor subscribers can use our portfolio projection tool to do this step with the portfolio value as your salary and the rate of return as the annual increase in salary.

Non-subscribers can use this online calculator to make the adjustment with present value representing your current salary, return percentage as the annual salary increase and zeroing out the additonal contributions.

Below is an example of $70,000 post-tax and post-super that you anticipate will grow 4% annual for a decade. Your estimated spending would be a little more than $103,000 at retirement.

Step 4: Adjust for other sources of income

The final step is to make adjustments for other sources of income during retirement.

Our goal is to come up with an annual spending total that needs to be supported by your portfolio.

Sources of income that will not come from your portfolio need to be removed to estimate how much you need.

One example of a non-portfolio income source is the age pension. But there are potentially several other sources of income including investment property, a private pension, an annuity or part-time employment if you are not fully retired.

Younger investors may want to exclude this step from your estimate if you lack confidence that a potential income source like the age pension will remain in the current form at your retirement.

After coming up with the total amount of additional income sources subtract them from your total spending needs you calculated after step 3.

You can now calculate the size of your portfolio needed to support retirement

Once you know your spending requirements, the last step is to calculate how large of a portfolio you need to support your estimated spending in retirement.

This takes a simple calculation. Divide the amount of spending needs you have in retirement by an annual withdrawal rate. We discuss withdrawal rates below.

If you have $69,000 in spending needs in retirement and a 4% withdrawal rate, simply divide 69,000 by 0.04 which gives you a total portfolio size of $1,725,000.

This figure can be adjusted over time as you encounter the twists and turns of life.

Those inevitable changes shouldn’t deter you from going through this exercise. Knowing where you stand will help you pivot from a position of strength. Adjusting your plan is always preferable than not having a plan at all.

Determining your safe withdrawal rate

The safe withdrawal rate represents the amount that you can take out of your portfolio in your first year of retirement to give you a reasonable chance of not running out of money prior to the end of your life.

This safe withdrawal rate factors in changes to the amount you take out after your first year that adjust for inflation so you can maintain a consistent standard of living.

We have written extensively on the different factors that go into this rate. My colleague Shani provides an overview of the oft-cited 4% rule. I've written a shorter version and this Investing Compass podcast episode summarises the report.

Traditionally the safe withdrawal rate is based on a 30-year retirement which covers the risk that you may live a long-time. If you envision retiring well before retirement age this is not an appropriate number to use and the withdrawal rate would have to be meaningfully reduced to cover a longer retirement period.

A 4% safe withdrawal rate is the personal finance benchmark and can be used if you have a long-time until retirement. If you are nearing retirement market conditions will dictate the returns you receive on your portfolio going forward.

Final thoughts

Saving and investing for retirement is a complex financial challenge. There are a myriad of factors that impact how much money is needed to support a given level of retirement spending. There are countless individual dynamics unique to each of us and our circumstances that influence the way in which a lump sum is spent over the course of retirement.

When presented with any complex problem human nature causes many of us to delay or ignore any meaningful exploration of issue. Knowledge is not necessarily a panacea. Often the more you know about retirement the more questions than answers come to mind.

We save for retirement over a lifetime and circumstances changes. However, the more informed we are about our own progress towards achieving our retirement goal the more likely we are to course correct in a beneficial way. Even if you are approaching retirement and are still short of your goals there are actions that can be taken to stretch retirement savings which I’ve outlined in this article. The best thing any of us can do is to get started. Estimating how much you need to retire is the first step.