How Much Do You Really Need to Retire?

By James M. Dahle, MD

It’s the number everyone wants to know. Find yours.

“How much do I need to retire?” is a common question, both among those physicians who have just started getting serious about saving, and among those who can see retirement in the near future. The answer, unfortunately, is “It depends.” However, a common misconception is that it depends in some form on your pre-retirement income. There are even formulas propagated in the media and by well-meaning financial advisers that indicate you will need to replace anywhere from 60 to 100% percent of your pre-retirement income. These formulas are worse than useless, they are misleading, especially for physicians. The truth is that the amount of money you need to retire depends primarily on your retirement living expenses and secondarily on the form of your assets. 

A typical physician will have dramatically different expenses in retirement than he had during his peak earning years. Consider all of the expenses you have now that you won’t continue to have as a retiree. You won’t pay payroll taxes as a retiree, and federal income taxes will often be much reduced, given lower overall income and the fact that some of that income will come from tax-free (Roth) accounts, Social Security (only 85 percent taxable), taxable assets that benefit from lower long-term capital gains and qualified dividend rates, and perhaps borrowed funds from cash value life insurance policies. You may even relocate somewhere with lower state and local income taxes.

Your insurance costs will go down, as you will no longer need malpractice, disability, or term life insurance. Medicare will assist with health expenses. Your child-related expenses, including saving for college, will most likely be dramatically reduced. Hopefully your mortgage is paid off. Even your charitable contributions may go down.

Most importantly, you will no longer need to save for retirement. In fact, it is quite possible for a typical physician to require only 25 to 50 percent of his peak career gross income in order to maintain the exact same lifestyle in retirement. However, the only way to really determine this is to run the numbers yourself. The closer you get to retirement, the easier this number will be to estimate.

The amount of assets needed to support a comfortable retirement also depends on the form of those assets. Guaranteed payments, especially inflation-indexed payments, such as Social Security, pensions, and single premium immediate annuities (SPIAs,) reduce your expenses dollar for dollar since they are guaranteed to pay you until the day you die. 

Other useful retirement assets, such as a portfolio of low-cost stock and bond index mutual funds, are harder to use to estimate retirement income. Studies of historical returns suggest a useful approximation is “the 4 percent rule,” which basically states that you can withdraw 4 percent of your original retirement assets, indexed to inflation, and expect that money to last throughout a long retirement. That means if you need your stock and bond portfolio to provide an income of $100,000 per year, you need a portfolio worth approximately $100,000 / 0.04 = $2.5 million at the time of retirement.

Some physicians may be concerned about the viability of the Social Security system given our country’s serious financial issues. While it would not be surprising to see additional means testing applied to Social Security (it is already means tested in the way payments are calculated and the income is taxed), the likelihood of the program disappearing completely seems very low given its popularity. The obvious solution for someone seriously concerned about Social Security viability is to save a higher percentage of their current income in order to make up for it.

The higher the rate of return of the investment, and the lower the volatility of that return, the more income you can take from the investment in retirement. Stock mutual funds, in particular, are highly volatile despite their overall high return, and thus suffer from significant sequence of returns risk. This is the possibility that your investment experiences poor returns in the first few years of retirement, which when combined with withdrawals to support your lifestyle, can rapidly deplete a portfolio. Income-producing real estate purchased at a reasonable price may have similar long-term returns to stock mutual funds. Since most of the return of a paid-off income-producing real estate investment comes from the cash flow (net operating income— the gross rent minus all expenses), many retirees feel comfortable spending most or all of the cash flow. Although the value of the property may be volatile, the cash flow is more stable, and the overall high return supports a reasonably high withdrawal rate. If the property has a capitalization rate (value of property divided by net operating income) of 6 percent, it may be very reasonable to spend 6 percent a year of the value, a marked increase from the 4 percent available from a stock and bond portfolio.

A physician retiree who determines he needs $120,000 of inflation-indexed gross income in retirement may find he gets $30,000 of it from Social Security. He may be able to purchase an inflation-indexed SPIA for $300,000 that produces another $15,000 per year. He may also own two income properties with positive cash flow of $20,000 per year. He would then need his traditional portfolio to provide the remaining $55,000 of retirement income, necessitating a portfolio of. $55,000 / 0.04 = $1.375 Million. 

How much you need to retire depends both on your expected retirement income and the form of your assets. The sooner you learn about and develop a retirement plan, the easier it will be to reach your goals.

James M. Dahle, MD is the author of The White Coat Investor: A Doctor's Guide to Personal Finance and Investing and blogs at http://whitecoatinvestor.com. He is not a licensed financial advisor, accountant, or attorney, and recommends you consult with your own advisors prior to acting on any information you read here.