Especially for people hoping to retire early, but also those just hoping they can retire at all, there's the question, "How much money do I need?" People who are already retired want to know "How much can I can spend, without running out of money?" Some people refer to the answer to the first question as "The Number." Really, though, these are both the same question.

There are a lot of ways to calculate your number. They all suffer from the same fundamental problem: nobody knows the future. To come up with the correct number you'd need to know (at a minimum) how long you'd live and what interest and inflation rates will be between now and then. Even if you knew those things, though, reality could come back and bite you.

Still, even without knowing the future, it's possible to take a useful stab at calculating your number. Here are a few of the classic methods.

Living on income

If there were no inflation, and you weren't desperate to retire early, this would be the number one choice: Save and invest until your interest and dividends reach the point that they cover your expenses. Once that happens, you're done and you can retire.

Of course, there is inflation. To deal with that, you need to reinvest enough of your income to replenish your starting capital each year.

For example, if your number were $1,000,000 and inflation turned out to be 2%, then you'd need to reinvest enough of your income that your capital was boosted to $1,020,000 by the end of the first year. As a practical matter, what you need to do is estimate future inflation and make sure that your income covers not only your expenses, but does so with enough left over to make those reinvestments.

If the government's inflation data could be trusted, this wouldn't be too hard. In fact, there'd an easy way to do it: invest in TIPS (Treasury Inflation-Protected Securities). They automatically do exactly what I've described--the face value of the bond adjusts so as to keep the inflation-adjusted value of the principle constant.

Unfortunately, the government's reported inflation numbers have been seriously understating the actual rise in the cost of living just lately. I don't tend to assign malice to this. (I've read some of the papers written by the economists at the Bureau of Labor Statistics, and they sound to me like sincere people trying very hard to produce honest numbers.) In the final analysis, though it doesn't matter what the overall inflation rate is. What matters is your own cost of living. You need to adjust your capital by however much your cost of living is going up, or else you're going to gradually fall behind.

Having some of your money invested in stocks can cushion this--there's a good chance dividends will rise, and there's a good chance the values of the stocks will rise. There's no guarantee that it'll match inflation (or even that it will happen at all), but it has generally happened for decades now.

Two other gotchas to beware of:

• Be sure that you know what your expenses actually are--any unexpected ones (taxes? a new car, new roof, new furnace? health insurance?) eat into your standard of living (or worse).
• Be sure your income is secure--it can be very tempting to take a little extra risk, to boost your standard of living, but that can bite you badly.

Now, all the fiddly detail work of adjusting for inflation aside, the real downside of living on income is that it takes too much money. Let's say you can live on $50,000 a year. The amount of money that you'd need to invest in TIPS to earn that $50,000 (guaranteed by the government and adjusted for inflation) would be something like $2.8 million. Now, if you've got $2.8 million (and you can live on $50,000), then you're pretty much all set. I wouldn't invest it all in TIPS--diversify into stocks as well--but a very straightforward investment plan will do the trick for you, and I think you can safely retire right now.

Most people, though, would like to retire without having to save up quite that much capital relative to how much money they're going to need to live on. Happily, that's almost certainly possible, if you make the (rather likely) assumption that you're not going to live forever.

Spending down capital

If you invest $2.8 million in TIPS and just spend the income, you'll eventually die with a nest egg worth (an inflation-adjusted) $2.8 million. That's great for your heirs, but doesn't otherwise do you a lot of good.

If you knew how long you were going to live, you could calculate how much of your capital you could safely spend each year, and die with any particular sum you wanted.

If you have a financial calculator, here's how to do the calculation. (If you don't, there are plenty of financial calculators on the web.)

Suppose you knew you were going to live for 34 years in retirement and wanted to die broke. You could plug in a Future Value of zero (dying broke), a payment of $50,000 (or whatever you need to live on), an interest rate of 1.85% (the current rate on 20-year TIPS) and solve for Present Value (the amount you need to invest today to get those 34 payments of $50,000 (adjusted for inflation because you're buying TIPS). It'll tell you that you need about $1.25 million--a big improvement over the $2.8 million income-only solution, assuming that you want to retire early.

If you knew you were going to die younger--for example, that you'd only live in retirement for 12 years--you wouldn't need nearly as much. In fact, just a bit over $500,000 would do the trick.

That's still pretty conservative, mainly because we're using the very low interest rate that TIPS are currently paying (just 1.85% over inflation). If you invest in a diversified portfolio of stocks and bonds, you can probably earn more than that. The average return in the stock market runs in the 10% to 12% range. Deduct 3% or 4% for inflation, and there's a good chance the stock market portion of your portfolio can return 6% or even 7% after inflation. Use that rate in place of the 1.85% you could get on TIPS, and you'll find that you can retire on a very modest amount of capital, as long as you're sure that you'll die on schedule.

People have long looked for a sweet spot somewhere in between assuming that you'll live forever (income-only spending) and assuming that you'll die on schedule (spending down capital). They've come up with a couple rules of thumb.

The 4% and 5% rules

Among people who invest for large institutions, there's a rule of thumb that you can spend 5% of your endowment each year, and then expect to have a bit more to spend next year than you spent this year.

Of course, they can't expect that 5% to be more every single year. Some years the investment portfolio does poorly--and after one of those years, the 5% that's available for spending will be less than the previous year. Maybe much less.

That may be okay for institutions, but it doesn't work so well for households. Most people, especially most retired people, don't have the flexibility in their budgets to easily accept, let's say, a 20% budget cut--an amount that's not only possible but entirely to be expected, if a good bit of your investment portfolio is invested in stocks.

For households, therefore, the rule of thumb is 4%. If you have a well-diversified portfolio of stocks and bonds, you can spend 4% the first year, and then increase the amount by the inflation rate each year, and you will very likely die before you run out of money. (In fact, you will very likely die with quite a large portfolio indeed, because you probably could have started out spending 5%.) But if you have enough capital that 4% will support you at an acceptable standard of living, then you're in a position to ride out a good bit more in the way of bad luck. (Such as, for example, a 20% drop in the market the very first year after you retire.)

Social Security, pensions, and other annuities

An annuity is a stream of money that gets paid to you until you die. You can buy one from an insurance company. Annuity payers are in a position to (roughly) follow the 5% rule, because they can play the averages. Some people will buy their annuity just before the market takes a 20% dive, but most people won't. Some people will live a very long time, but most people will live an ordinary length of time and a few will die young. If you die young, they keep the rest of the money, and that puts them in a position to pay out more than you could safely spend yourself.

It's worth having some sort of an annuity, as a fall-back in case you both face poor investment returns and live a long time. As I said, you can buy one from an insurance company, but you may not need to, if you have a pension.

Pensions are a special case of annuity. In the old days, many people earned some sort of pension, if they worked for a largish company for many years. These days, they're pretty rare, but lots of older folks are still owed a pension from jobs that they worked back when they were more common.

If you have a pension, even a pretty small one, you may not need to annuitize any more of your capital. But, if you don't have any pension at all, an annuity is worth considering.

Besides the now-rare pension, almost every worker in the US is promised a Social Security pension (and people in other wealthy countries have similar promises from their governments). I don't know about the situation in other countries, but in the US a lot of people are dubious about that promise being paid in full--and with good reason. My own take on the situation, though, is that most people will actually get a large fraction of what they've been promised. In fact, it would be pretty easy to adjust things to pay people nearly all of what they'd been promised, if they did the adjusting sooner rather than later.

At any rate, the way to deal with any sort of annuity, Social Security or otherwise, is to discount it by however much you think is appropriate (against the risk that you won't get the whole thing), and then deduct what's left from the amount that you want to spend each year. Your investment portfolio needs to cover the remainder.

The answer

So, that's your answer for the questions we started with.

How much do you need to retire? Take what you want to spend, subtract the amount you confidently expect to receive from Social Security and any other pensions or annuities you've got coming to you, and then divide by 0.04.

How much can you spend? Multiply your investment portfolio by 0.04 and then add whatever you're getting from Social Security and other pensions (suitably adjusted, if you're not confident you'll keep getting them).

There are too many variables for it to be safe to put any of these things entirely on autopilot. When you figure the inflation adjustment for next year's spending, cross check to see if you're spending more than 4% of your capital. (If the market hasn't kept up with inflation, you probably will be.) If that's true, you'd be well advised to cut your spending a bit--a few bad years, especially early in retirement, can put a portfolio into a hopeless downward spiral if you go on spending without regard to how much money is really there.

If you can earn some money in retirement, even a pretty modest amount, that can take a big weight off the investment portfolio. Well worth trying, even if just for a few years early on.