The rule of $1,000 may help you figure out how much dough you need to save for retirement. You can guess, of course. Or go with a big round number like $1 million. Or hire a financial adviser to run the numbers in a retirement plan. You can also use the rule of $1,000. Also called the “$1,000-a-month-rule,” this back-of-the-envelope guesstimate tells you the amount you must save in your 401(k), IRA, or 403(b) to generate a certain amount of monthly income.
Here’s the skinny on the rule, popularized by certified financial planner Wes Moss, author of “What the Happiest Retirees Know: 10 Habits for a Healthy, Secure, and Joyful Life.” The savings guideline states that for every $1,000 of monthly income you want to generate in your golden years, you’ll need to have $240,000 saved in your retirement account. The rule assumes a 5% annual withdrawal rate and a 5% return.
The math works like this: Withdrawing 5% of the $240,000 balance each year generates $12,000 in income annually, or $1,000 a month. ($240,000 X 0.05 = $12,000 per year / 12 = $1,000 a month.
How to use the rule of $1,000
To use the $1,000-a-month rule, tally up all the monthly expenses you expect in retirement, such as housing costs, food, transportation, health care, and entertainment. Once you estimate what your monthly expenses will be, you can also get a rough calculation of how big a nest egg you’ll need to pay the bills (we've got a retirement calculator that can help). Remember, it’s not just personal savings that will help you make ends meet. In retirement, you’ll also likely have other sources of income, such as Social Security, a work pension, or an annuity, to name a few.
Let’s say you think you’ll need more cash, say $3,000 a month, to fund your retirement lifestyle. The new numbers would be: $720,000 X 0.05 = $36,000 per year, or $3,000 monthly.
Let’s be clear: the $1,000-a-month rule isn’t a precise financial planning tool. What it is, though, is a concept that’s easy to understand and easy to apply.
“It’s one of those rules of thumb that (the wealth management industry) try to give people to help simplify their financial planning,” said Tim Steffen, director of advanced planning at Baird Private Wealth Management.
The rule of $1,000 is best suited for younger savers with very long-term horizons.
“For somebody younger, say in their 30s, that’s doing long-range forecasting and trying to come up with a reasonable savings number to target, it can be a good starting point,” said Steffen.
However, for savers in their late 50s and early 60s approaching retirement, the $1,000-a-month rule lacks the specificity required to truly ascertain what a retiree's true income needs and funding requirements will be, adds Steffen.
The rule of $1,000 downside
Like most simplistic retirement guesstimates, personal finance pros say there are drawbacks. It doesn’t account for all the unknown variables that will impact savings and spending over one’s lifetime.
One of the downsides of the rule of $1,000 is the 5% withdrawal rate, which errs on the aggressive side. A popular retirement withdrawal strategy, for instance, is the 4% rule. This simple rule of thumb calls for just 4% of savings to be withdrawn in the first year of retirement and then withdrawing the same amount plus adjustments for inflation in the following years. This strategy is designed to provide withdrawals for 30 years without depleting the saver’s nest egg.
Jason Fannon, senior partner at Cornerstone Financial Partners, recommends this more conservative withdrawal strategy and says, in some cases, a 3% annual distribution might be prudent.
“The 5% withdrawal per year would worry me,” said Fannon. “A lower withdrawal rate would essentially ensure that you hit your income goal. If you’re doing any modeling as a layperson, I would use a withdrawal rate that’s more conservative (than 5%). Anything over 4% is fairly aggressive.”
The higher 5% withdrawal amount could prove difficult in low interest rate environments, as lower yields net less income, Fannon says. That places a greater reliance on the retiree to generate income from more volatile assets, such as stocks, and a more aggressive portfolio. And that subjects a nest egg to more risk from market fluctuations. Drawing down 5% could also put retirees at greater risk of running out of money. “There’s a greater risk of spending that money down,” said Fannon.
The smaller the annual withdrawal, the more assets are needed to generate the same amount of income. Using the same math to generate $1,000 in monthly income at a 3% or 4% withdrawal rate means having more savings to support the $1,000 in income. At a 4% annual withdrawal rate, you’ll need $300,000 in savings, says Fannon. And if you only want to draw down 3% per year, you’ll need a 401(k) balance of $400,000 to generate $1,000 in income.
Steffen also cautions that the $ 1,000-a-month rule doesn’t specify a timeline for how long the lump sum will last but rather on a savings target.
If the $240,000 needed to generate the $1,000 in monthly income doesn’t deliver a return, for example, the money would last just 20 years. “And many people have longer retirement periods than 20 years, said Steffen. And withdrawing a hefty 5% of your savings each year compounds the problem. “Anytime you increase your withdrawal rate, you increase the chance of running out of money,” said Steffen.
What’s more, the simplistic rule of 1,000 doesn’t take inflation into account. Steffen says that the $1,000 in income you might need today might not be enough to fund your lifestyle years from now. Moreover, if the $240,000 is sitting in a traditional 401(k) or IRA, withdrawals will be taxed at the retiree’s regular income tax rate. That means the $1,000 you withdraw might only net $800 or $850 in spending power.
So, should you use the rule?
Despite the drawbacks, that’s not to say there’s no useful information that can be gleaned from the rule of $1,000, says Steffen.
“You have to start somewhere, and maybe this a place to start,” said Steffen. “But if I’m a 62-year-old and I’m trying to decide if I can retire now or do I need to work a few more years, I don’t want to use one of these catch-all benchmarks. As you get closer to retirement, you need a more customized financial plan.”
