Sunday, August 9, 2009

Retirement Planning: How much money do you need to retire?

Have you ever tried to figure out how much money you'll need in order to retire?

ABSOLUTELY NOT!

At least if you are like 58% of active workers, you haven't. That's right, 58% of workers have NEVER tried to calculate what they need to save for a comfortable retirement…

And “only 42% of active workers have ever tried to calculate how much they need… and 8% of those admitted they arrived at their answer by guessing,” reported National Underwriter on April 24, 2006. So, let's figure out what you need.

How to Begin?

Asking someone you haven't met how much you need to save for retirement is like inquiring how long they figure it will take you to get to Los Angeles. They really ought to respond with some very basic follow-up questions like "Where are you now?" and "Are you driving or flying?"

When it comes to how much to save for retirement, there are several key questions and considerations you should evaluate as you contemplate a retirement, either with or without the assistance of a planner.

What do you envision for your retirement?

Does your ideal retirement life look a lot like the one you have now? Or would you hope to step it up a notch? Alternatively, you may crave the idea of an earlier retirement even at the expense of a lower standard of living. There's no right or wrong answer, but your anticipated retirement lifestyle is a critical component in answering the "How much?" question.

What do you make today?

Your current income is a useful starting point for calculating your retirement planning needs. Odds are that the more you make today, the more you'll need in retirement - thanks to the lifestyle creep prevalent in today's society. If you're different than most, congratulations - you can probably save less. But it won't matter, because you're already saving more.

How much will you collect from Social Security? Will you receive any defined benefit pension benefits during retirement?

These monthly payments can subtract substantially from the amount you may have to save. Getting a good estimate is invaluable as you plan your retirement and determine your savings need.

When will you retire?

The younger you are when you retire, the longer you can expect to live during retirement. This means you'll need more saved. If you wait longer until retirement, not only will you be retired for a shorter amount of time, but you will also work more years, meaning you can save more.



A Sample Calculation 

Before you begin with the sample calculation, a word on 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 amount - 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.

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 2-4% 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 1.04
  • 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 of the effects of inflation, which 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 a lot of 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 could occur, resulting in John's actual nest egg falling 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 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, there are many uncertainties that 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.

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. 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.

Whatever the reason, the reality is that a part-time job during your golden 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.

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 well into your golden years. Remember that along with advances in health care, average life spans are increasing. According to the National Center for Health Statistics, the average lifespan in the U.S. in 2004 (the most recent year for which data is available) is 77.9 years, so don't sell yourself short!


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