No one on the verge of retiring wants to suddenly realize they can’t afford to retire. That’s why it’s essential to start planning long before you hang up the stethoscope. If you start the saving process and prepare in advance of your retirement date, you should be well on your way to reaching your retirement financial goals.
Physicians have many financial decisions to make regarding retirement, including calculating their nest eggs.
Calculating Your Nest Egg
Figuring out how many years your retirement savings will last isn’t an exact science. There are many variables at play — investment returns, inflation, unforeseen expenses — and all of them can dramatically affect the longevity of your savings.
The simplest way to arrive at an amount is to compare your total savings, plus investment returns over time, against your annual expenses.
Numerous calculators are available on the internet that can be helpful. One example is the Vanguard calculator, which requires that only a few numbers be inserted to arrive at the nest egg amount needed for retirement (https://investor.vanguard.com/tools-calculators/retirement-income-calculator ).
Below is a four-step method for determining the nest egg that you will need for a financially sound retirement.
Step 1. Calculate your monthly expenses.
Calculate your monthly expenses. Based on those calculations, make a budget showing how much of your income you must save to reach your retirement goals. This means creating a budget that will maintain your lifestyle but will allow you to put aside funds for retirement. A recent U.S. Bank study found that approximately 60% of Americans admitted that they didn’t create a budget or that they don’t follow one.(1)
Determine how much you’re currently spending on non-essentials. With that information, in addition to your basic expenses, you’ll be able to identify ways to cut corners and free up some cash to contribute to a retirement account.
Begin by making a list of your basic monthly expenses (i.e., rent/mortgage, groceries, entertainment, taxes, insurance including health insurance if you are younger than 65 and will not be eligible for Medicare.) Review these monthly expenses and determine how they will change in retirement. For example, if you downsize to a smaller home, your mortgage and property taxes will probably decrease; travel expenses might increase should you decide to travel upon retirement.
Next, using your bank and credit card statements, list all expenses from the past three months and show the total for each category. After adding up the total expenses for the previous three months, divide by three to determine your average monthly expenses.
Finally, determine what is left over from your current income to save for your financial future. Most financial planners suggest that you aim to save 20% of your after-tax income. Now, go through each category and decide how much you can spend while still reaching your goal of savings to fill your nest egg.
Step 2: Calculate your annual expenses.
Multiply your average monthly expenses by 12 — this provides your anticipated annual expenses. If you are using a retirement calculator, enter your current savings and how long you plan to work until you retire. Then include your expected after-tax return on your investments. Be conservative, e.g., a 5% return on your investments. It is far better to underestimate your return on investment and have more funds later or be able to reduce your contribution or, even better, retire earlier than anticipated.
The bottom-up approach is recommended when you’re trying to get a handle on where your money goes and where you can reduce spending. Cutting back on spending can make it possible to retire earlier or on your timeline and not worry about finances when you pull the retirement trigger. If you have children, this activity can be a valuable opportunity to teach them how money works and how to manage it wisely.
Step 3: Determine how big a nest egg you will need.
Once you know how much money you want/need annually for retirement, you can calculate the amount of your nest egg.
The calculation outlined above does not directly factor in passive income such as rental income or dividends from your investment portfolio that can sustain you during retirement. To factor in the passive income, subtract your expected annual total of passive income from your expected yearly expenses. Then calculate the savings needed to reach a now-amended nest egg based on the amended yearly savings that consider your estimated passive income.
Apply the 4% rule. The 4% rule is based on past U.S. investment returns for a retiree expecting to live an additional 30 years after retirement. It’s a simple equation based on the 4% rule, which evolved from a 1994 research paper by financial adviser William Bengen.(2)
Bengen looked at how long a portfolio would last if you started drawing down 4% of the initial value in the first year of retirement and then upwardly adjusted the withdrawal amount each year based on future inflation. Bengen tested different portfolio mixes of stocks and bonds to support a 4% withdrawal rate and advised investment in stocks between 50% and 75%. This scenario will result in your having enough funds for a comfortable retirement and having money to leave for your family at the time of your death.
This assumes that you will withdraw approximately 4% of your retirement capital each year; however, it will require adjusting the income annually for inflation.
If you divide your annual desired retirement expenses by 4% (or multiply by 25), you will have the estimated nest egg required for you to maintain your lifestyle during your retirement. Using this 4% rule, if you have $3 million saved at the time you retire, you could expect to take out $120,000 in year one; then, if inflation is 3%, you could expect to take out $123,600 in year two, and so on. The 4% rule is a rule of thumb to arrive at a target savings number.
Don’t forget about Social Security benefits and Medicare costs. If physicians can wait until the age of 70, when it is mandatory to start receiving Social Security benefits, they will essentially add another million dollars to their retirement net worth. How? The full benefits for a worker who has paid into Social Security for the duration of a lengthy career approach $50,000 yearly. Benefits a spouse may receive may increase this benefit even more.
By using only the $50,000 yearly benefit and the 4% rule, one can multiply $50,000 by 25 and realize this benefit works out to $1,250,000 added to the beneficiary’s net worth. No, it’s not “money in the bank,” but it is the equivalent of removing 4% yearly from $1,250,000 “in the bank.”
Keep in mind that Medicare expenses will be deducted monthly from the Social Security benefit; the amount depends on the previous year’s tax reporting. In addition, depending on the scenario, the Social Security benefit is taxable income. One must always be aware of a variable that is completely uncontrollable, such as changes in tax laws.
Reverse mortgage may be a way to enhance your nest egg. A reverse mortgage is a federal government-insured program whereby a homeowner may tap into the equity in their primary residence. Most of these loans are insured through the Federal Housing Administration (FHA).
If you are retiring and are 62 or older, you may take out a portion of the equity in your home either as a monthly payment or as a lump sum. No payments are required by you, the homeowner. It is a loan, so it will need to be repaid upon the sale of the home, either by the owner or their surviving family.
As an example, suppose the reverse mortgage on a $1 million home is $400,000. Depending on the life of the loan, when the home is sold for $1 million, the $400,000 will need to be repaid, plus accumulated interest. There are a few restrictions; a person cannot have an IRS lien or unpaid student debt. There is abundant information on reverse mortgages online.
Step 4: Determine your required savings rate.
The best results are obtained when you increase the difference between your annual income and your annual expenses, i.e., what you spend on an annual basis. This difference is referred to as your “margin.” With the assistance of a certified financial planner, you should consider investing this margin.
To determine your required saving rate to reach your retirement nest egg, consider these four variables:
How much you will need to save each year.
How much you already have saved.
Your expected rate of return on your savings.
How long you have until you plan to retire.
Please note that three of these four variates (1, 2, and 4) are within your control; however, No. 4 sometimes is not.
Bottom Line
The decision to retire is one of the most important decisions you will make, probably only second to selecting a life-long partner. This decision requires careful planning and moderation in your spending to achieve the nest egg that will allow you to be financially comfortable during the final third of your life.
Preparing a budget and knowing how much income you will need during retirement are crucial metrics for your retirement success. The four-step plan using an online calculator will help you start. If you love numbers, math, and spreadsheets, you might have the skill set to DIY (Do It Yourself) to model your retirement. But if that isn’t your skillset, obtain the services of a financial planner — ideally one who has experience working with the medical profession.
In the third and final article on retirement, we will provide suggestions for managing the void that arises when your work week goes from 50-60 hours to zero hours. We will show you that every day can be like Saturday and Sunday!
References
Waterhouse R. From the CEO — The Importance of Planning for Your Retirement. Equity. 2021;35(10):3.
Templin N. The Originator of the 4% Rule Thinks It’s Off the Mark. Barron’s. Jan. 23, 2021. www.barrons.com/articles/the-originator-of-the-4-retirement-rule-thinks-its-off-the-mark-he-says-it-now-could-be-up-to-4-5-51611410402