Your Nest Egg: How Much Do You Need to Retire?

By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA

With employers shifting away from traditional pension plans to defined contribution plans such as the 401(k), most of us are responsible for building a nest egg that will provide the financial security we need in retirement.  How much do you need to have in your 401(k) account in order to retire? To answer this question, we recommend that you follow three basic steps.

In our discussion, we focus on Traditional 401(k) plans, where retirement distributions are taxable. For Roth accounts, you would reduce the required balance to reflect the fact that distributions from Roth accounts are tax-free.  Our discussion applies equally to 403(b) plans and IRAs.

The first step is to estimate the level of before-tax income, in today’s dollars, that you desire to receive annually in retirement. In general, we recommend starting with your current salary. Deduct 401(k) and Social Security contributions since these will no longer be funded in retirement. Most people find they can live comfortably on 80-100% of this income target, which is measured in before-tax dollars.

The second step is to determine how much of this income needs to come from your retirement accounts – the combination of your 401(k) plan, IRAs, and other investments that are earmarked for retirement. Deduct your estimated Social Security income (this estimate can be obtained from the Social Security website), any pension income that you are entitled to receive, and income from any other sources outside your retirement accounts such as rental properties.

Since Social Security payments are indexed to inflation, the Social Security estimate is already in today’s dollars. But, if you have a pension, you will likely need to modify its projected income for inflation since most private pensions are not inflation indexed. A rough method of adjustment is to reduce the projected pension income by 30%, which gives you the average real annual income, assuming that the pension income begins at age 67, you live to age 90, and inflation averages 3 percent.

The third step is to estimate the size of the portfolio needed to generate the remaining income. For general planning purposes, we typically multiply the desired income by 20. For example, suppose you have estimated that you want your 401(k) account to generate $30,000 per year, in today’s dollars. Multiplying by 20 gives you a target of having $600,000 (in today’s dollars) in your 401(k) account by the time you retire.

Using the multiple of 20 provides a good estimate if you are planning to retire at age 67, and you need the income to cover both you and your spouse for the rest of your lives. The multiple is based on how much it will likely cost to buy an inflation-protected annuity that will generate the necessary level of income. You may certainly decide against buying an annuity and choose to draw upon your portfolio of investments. But, for planning purposes, we like basing calculations on an instrument that will provide income as long as you live and also offers protection against inflation.

The price of an annuity depends upon your age – the older you are, the less it costs to buy the desired level of income. An annuity pays income as long as you live so an older retiree will, on average, receive fewer payments. In order to retire at age 62, the appropriate income multiplier is 23.

These multiples also assume that today’s very low interest rates return to more normal levels by the time you reach retirement. Economists expect interest rates to return to more normal levels in 5-10 years, and we agree. If you are planning to retire within the next few years, or if you wish to be conservative, consider using a higher multiple. For example, with current interest rates, a couple retiring at age 67 should use a multiple of 23, and the couple planning to retire at age 62 should use a multiple of 25.

There is one more step if you plan to incur any one-time expenses when you retire, such as an around-the-world cruise.  In particular, if you plan to retire prior to drawing Social Security, additional funds are required to cover the income shortfall during those years.  You need to add these one-time expenses to your total.