So now that we've been through the important parts of the why, let's start tackling the how of retirement planning by asking the No.1 retirement question: "How much money do I need to retire?"
The answer to this question contains some good news and some bad news.
First, the bad news: There really is no single number that would guarantee everyone an adequate retirement. It depends on many factors, including your desired standard of living, your expenses (including any medical costs) and your target retirement age.
Now for the good news: It's definitely possible to determine a reasonable number for your own retirement needs. All it involves is answering a few questions and doing some number crunching. Provided you plan ahead and estimate on the conservative side, you should be able to accumulate a nest egg sufficient to last you through your retirement years.
There are several key tasks you need to complete before you can determine what size of nest egg you'll need to fund your retirement. These include the following:
- Decide the age at which you want to retire.
- Decide the annual income you'll need for your retirement years. It may be wise to estimate on the high end for this number. Generally speaking, it's reasonable to assume you'll need about 80% of your current annual salary in order to maintain your standard of living. (To learn more about how to do this, see Determining Your Post-Work Income.)
- Add the current market value of all your savings and investments.
- Determine a realistic annualized real rate of return (net of inflation) on your investments. Conservatively assume inflation will be 4% annually. A realistic rate of return would be 6% to 10%. Again, estimate on the low end to be on the safe side.
- If you have a company pension plan, obtain an estimate of its value from your plan provider.
- Estimate the value of your Social Security benefits. Start by clicking here for the calculator on the Social Security website.
A Sample Calculation
Before we begin with our sample calculation, a word about inflation. When drawing up your retirement plan, it's simplest to express all your numbers in today's dollars. Then, after you've determined your retirement needs (in today's dollars), you can worry about converting the numbers into "tomorrow's dollars," i.e. factoring in inflation.
Just remember not to mix the two. If you do, your numbers won't make any sense! After all, how do you contribute $300 in 2025 dollars each month to your retirement plan?
Compute all of your numbers in today's dollars. When you are finished, you can apply an inflation assumption to get a realistic estimate of the dollar amounts you will be dealing with as you make your contributions over the decades.
Now on to the sample calculation. Consider the hypothetical case of John, a 40-year-old man currently earning $45,000 after taxes. Let's go through the key factors for John:
- John wants to retire at age 65.
- John will need $40,000 of annual retirement income – in today's dollars (i.e., not adjusted for inflation).
- John currently has $100,000 in savings and investments.
- Over 25 years of investment (age 40 to 65), John should realistically earn a 6% annualized real rate of return on his investments, net of inflation.
- John does not have a company pension plan.
- Visiting the SSA website, we can quickly calculate John's estimated social security benefits in today's dollars. Assuming John is born on today's date 40 years ago and will retire 25 years from now, we can retrieve his estimated Social Security benefits in today's dollars. The SSA website gives us a value of around $1,300 per month.
Now, John determined he would need $40,000 (in today's dollars) annually to live during his retirement years. To the nearest $100, this works out to about $3,300 per month. Assuming John's Social Security funds come through as estimated, we can subtract his estimated monthly benefits from his required monthly income amount.
This leaves him with $2,000 per month that he must fund on his own ($3,300 - $1,300 = $2,000), or $24,000 per year.
John is in good health and has a family history of longevity. He also wants to make sure he can pass along a sizable portion of wealth to his children. As a result, John wants to establish a nest egg large enough to enable him to live off of its investment returns – and not eat into his principal – during his retirement years.
Because John should be able to earn 6% annualized returns (net of inflation), he will need a nest egg of at least $400,000 ($24,000 / 0.06).
Of course, we haven't accounted for the taxes John will pay on his investment income. If his capital gains and investment income is assumed to be taxed at 20%, he will need a nest egg of at least $500,000 to fund his retirement income, since a $500,000 retirement fund earning 6% real returns would produce income of $24,000 after 20% taxes. Consider, too, that any tax-deferred retirement assets will be taxed at his ordinary income tax rate, leaving him with even less disposable income. (To learn more about this, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax.)
Keep Inflation in Check
Now, keep in mind all these numbers are expressed in today's dollars. Since we're talking about a time period spanning several decades, we'll need to consider the effects of inflation. In the United States, the federal government has kept inflation within a range of 2% to 4% for many years, and analysts project that it will remain within that range for a while. Therefore, assuming 4% annual inflation should keep your projections from falling short of your actual financial needs.
In John's case, he needed a $500,000 (in today's dollars) nest egg 25 years from now. To express this in the dollars of 25 years from now, we simply multiply $500,000 by 1.04, 25 times.
This is equal to 1.04 to the twenty-fifth power, multiplied by $500,000. So, we have:
- Nest Egg = $500,000 x 1.0425
- Nest Egg = $500,000 x 2.67
- Nest Egg = $1,332,900
As you can see, the $1.3 million dollar nest egg is a much larger number than the $500,000. This is because inflation causes purchasing power to erode over time and wage rates to increase each year. Twenty-five years from now, John won't be spending $40,000 per year – he'll be spending $106,600 ($40,000 x 2.67).
Either way, for the purposes of our retirement calculation, the inflation assumption doesn't really matter. A $500,000 nest egg and a $40,000 budget expressed in today's dollars is the same thing as a $1.3 million nest egg and a $106,600 budget 25 years from now, assuming inflation has run its course at 4% per year.
The key is that we assume that savings will grow at a real rate of return of 6% annually. The numbers would actually be growing at 10% annually, but inflation would be running at 4%, so the growth in purchasing power would actually be 6% per year.
You don't need to worry about this too much for your retirement plan, but just keep inflation in mind when you determine how much you want to save for your nest egg every month. A $200 monthly contribution is nothing to sneeze at right now, but after 20 or 30 years, $200 won't buy you very much. As you continue with your retirement plan year after year, simply check the inflation number each year and revise your contributions accordingly. Provided you do this, you should be able to grow your capital at your estimated real rate of return and reach your target nest egg.
There's No Magic Number
Of course, there are many changes to these financial estimates that could end up making John's $500,000 target nest egg too small. Poor return on investments, increased taxes, unexpected medical expenses, or a reduction of Social Security benefits make John's actual nest egg fall short of projections.
Because of this, it's best for John to provide himself with a margin of safety. Suppose that his Social Security benefits are discontinued. This would leave John with the burden of producing a pre-tax retirement income of $50,000 (assuming John's investments would be taxed at 20%, he would need to earn $50,000 in investment income per year in order to reap annual in-pocket income of $40,000).
At a 6% rate of return (net of inflation), John would need a nest egg of about $850,000 in order to accomplish his retirement goal. This would be a conservative target for his retirement goals (i.e., it is safer than assuming a $500,000 nest egg will work). A smaller nest egg might very well be sufficient to fund his retirement, but as we've already outlined, many uncertainties can derail his retirement plan along the way, so it's best to err on the side of caution.
The point here is that the original number we came up with for John's nest egg is the bare minimum. When you do your calculations, start with the bare minimum and then try to provide yourself with a sufficient margin of safety by assuming worst-case scenarios, such as an unplanned long-term illness.
Other Factors Come into Play
Even if your financial estimates are not fully realized – for instance, your investments earn lower-than-projected returns, Social Security benefits don't come through, tax rates are higher than projected, etc. – there are other factors that can change the retirement picture dramatically.
For example, if you are considering retiring early, you won't have access to such benefits as Social Security or pension funds until the specified age (at least, without penalty). Therefore, if you are planning to retire at 55, be sure to determine whether you will have access to the entire balance of your retirement savings at that time. (For more on this, read Retiring Early: How Long Should You Wait? and Retire In Style.)
In our above example, John's retirement plan included a significant amount of capital to be passed on to his heirs. You may wish to "die broke," or you may wish to leave a large inheritance for your children or to give to a charity. Either way, these decisions can impact your financial plan considerably.
On the flip side, it is becoming increasingly common for retirees to choose to work part-time during their retirement years. Some who choose to work during their retirement do so for personal-fulfillment reasons, others may do it for the extra income it provides. (To learn more about this option, see Stretch Your Savings By Working Into Your 70s.)
Whatever the reason, the reality is that a part-time job during your later years can do wonders for financing your retirement. For instance, if you've neglected saving for retirement until late in the game, a part-time job during retirement may be a critical part of your plan. If you decide that you will be working during your retirement, you will likely be working on a part-time basis. Be sure to consider this in your calculations and estimate conservatively, as your salary will likely be reduced from what you were used to earning before your retirement years.
If you have any substantial retirement plans, such as buying a summer home or traveling frequently, be sure to include these numbers in your financial projections, as it is likely that you are not incurring costs such as these during your pre-retirement years.
Also, consider your time span until retirement. If you are drawing up your financial plan only a few years before you intend to stop working, you will not be able to risk very much of your investment capital, and consequently your return estimates should be on the low side. Conversely, if you have 30 or 40 years to go until your desired retirement date, you can realistically aim for 10% or more in annualized returns. (To read more about this, see Delay in Savings Raises Payments Later On.)
Finally, while the idea may seem a bit grim, honestly consider your expected life span and make sure your financial plan can sustain your retirement if you live a long time. Remember that along with advances in healthcare, average life spans are increasing. According to the National Center for Health Statistics, the average life span in the U.S. in 2015 (the most recent year for which data is available) is 78.8 years. And if you make it to 65, the life expectancy is 19.4 years more – past age 84.Retirement Planning: Where Will My Money Come From?
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