In my previous post I discussed the first step in determining how much money you’ll need in retirement: calculating your future living expenses. Today I will discuss the second step which is to determine how much savings you’ll need to cover those expenses. After reading this, you should be able to get a reasonable estimate of the total amount you’ll need to save.

Let’s assume that you’ve calculated $100,000 per year in retirement expenses beginning the first year that you retire. The next step is subtracting your projected Social Security payments from your total needs. I recommend that you register for a My Social Security account on ssa.gov. You can get a personalized retirement benefit quote that is based on your earnings history. Be sure to run the quote using future value dollars, not present value. This will be more accurate than using a social security projection tool that is usually just based on your current salary. Social Security benefits will be an important part of your retirement income, so try to get the most accurate projection. If you want to be conservative with the number, you may want to just include a percentage of it, such as 85%. In fact, if you are 20 years away or more, I recommend doing this. The closer you are to claiming your Social Security benefit, the more accurate your quote will be.

Assuming you’ll receive $36,000 from Social Security, that leaves you with $64,000 per year that you’ll need to cover. If you are fortunate to have a pension plan, subtract the annual amount from your remaining income needs. If your pension is $20,000 per year, then your remaining uncovered needs will be $44,000 per year. Keep in mind that some pensions have a cost-of-living adjustment similar to Social Security, while some pay a fixed amount for life. If your pension pays a fixed amount, then this isn’t so straightforward and will require further calculations.

If you have any other income (like rental properties), subtract this amount from your retirement income needs as well. Once again, if it is fixed or if it will end at some point, then your situation will require more extensive calculations.

Now that you’ve calculated a need of $44,000 per year in income on top of Social Security and pension payments, you’re getting close. If you use a conservative withdrawal rate of 4%, then you’ll need to accumulate $1,100,000 ($44,000 divided by .04).  The 4 percent retirement rule* refers to the amount of money you might withdraw each year from the starting value of your portfolio of stock and bonds in retirement. You could then increase that amount with inflation and have a probability of almost 95% that your money would last for at least 30 years, assuming your portfolio allocation was 50% stocks and 50% bonds. If you use a 5% withdrawal rate, then you’ll need to accumulate $880,000 ($44,000 divided by .05). In general, the higher the initial withdrawal rate that you use, the more risk you’ll have of running out of money.

This process works if your situation is simple…your income comes from Social Security and retirement savings (401(k) and IRAs) and your expenses don’t change too much throughout retirement. But keep in mind that this is a ballpark estimate only. Things get trickier when there are more moving parts. Examples include if your expenses will change (house paid off at age 70, for example) or your income changes (part-time job for 10 years or a sale of some property or business), or there are timing issues (spouses retiring at very different dates). In those situations, I can help you model all of the possible scenarios. Retirees have shown an incredible ability to adapt their spending to their income. I think it’s wiser, however, to have an income goal and match it up with a plan to make it happen.

*The 4% Withdrawal Rule is based on a 1994 study by William Bengen, an investment management specialist, who explored sustainable withdrawal rates for retirement portfolios. Many experts disagree on whether it is still valid. For instance, the 4% rule assumes the retiree’s expenses are consistent from year to year, increasing only with inflation. In reality, spending could vary from one year to the next. Think of it as a guideline for this exercise, and not a rule.