How to Calculate What You'll Need to Retire
Get an Estimate of Your Retirement Savings Goal
How do you figure out exactly how much you need to retire? It's not easy. Well, it starts out easy, but then it gets pretty complicated. The easy part is coming up with a theoretical number to start with, which involves a lot of assumptions and estimates. The complicated part is how to estimate or assume for real life, which can trick us into thinking things will always be fine or terrible even though we have no idea what's going to happen.
Still, if you can ignore "the unknowable," you can come up with a perfectly reasonable retirement number. Here's how.
What's Your Retirement Lifespan?
You start by estimating how many years you will live in retirement. Talk about the unknowable, right? But look at the average life expectancy for someone of your age and gender, plus consider the ages at which your grandparents or parents may have passed away and you may get a sense of your own lifespan. Factor in what age you expect to retire. For example, if you hope to retire at 65 and you think you will live to 85, then you expect to live in retirement for about 20 years. You could live on well past 85 or not, but, for now, you have a goal to start with.
What's Your Retirement Salary?
The next thing you want to estimate is how much of today's income do you need to live on. In retirement, you may be able to cut expenses (by getting the kids raised, downsizing the house, or eliminating debt including the mortgage) and live leaner than you do now, or you may want the same standard of living you currently have.
At a minimum, you should plan on needing 80% of your current income, an even better rule of thumb is 85%. Or you may be set on 100%, shooting for a higher standard of 120%.
Say Jaime makes $50,000 currently. After creating a budget, she decides she could actually live on $40,000, so she sets her retirement goal at 80% of her current income.
She plans to retire at 70 and with her family's track record she figures she will likely live to about 90.
The simplest calculation is $40,000 x 20 years = $800,000. But, like I said, this is a complicated exercise. What you really want is an amount that generates in annual interest the money you need to live on. In this case, the $800,000 may actually work. If you had $800,000 and invested so that you were earning 5% annual interest, your portfolio could pay $40,000 a year without you having to touch the principal. Of course, some years the market returns much less and in some much more. If you have a lower annual return assumption, say 3%, then you would need nearly $1.4 million to generate $40,000 per year. And that's not even considering inflation, taxes or long years of poor performing markets. Particularly if you retire during one of these periods, it can have an impact on your assumptions. See what I mean about complicated?
But market performance and inflation are just two of the things that get complicated when you move away from the hypothetical and into reality scenarios. There's also Social Security. If you receive Social Security, that will help you meet monthly expenses.
If Jamie needs $3300 a month to live and Social Security pays $1500 a month, her share is reduced to $1800. That would cut in half the amount she needs to save to live on in retirement. But we all know the issue of Social Security is complicated. We all receive those annual statements in the mail letting us know what our annual amount would look like. If you are an optimist, you can go with that number as your hypothetical, or reduce to scale according to your level of cynicism (OK maybe realism, but I have hope).
Complications Can Derail Retirement Assumptions
Jamie may want to still shoot for a higher goal. Not just because she's skeptical she'll ever see a Social Security check or she thinks taxes and inflation have no place to go but up, but also because she wants to plan for those unexpected expenses that could eat away at her retirement budget.
Health care and health problems being the obvious example. One life-threatening illness could quickly wipe out a portion of her savings and the interest it gives off. She can plan during her working years to put money aside each month for long-term care insurance, which helps pay for in-home and facility nursing care. But there will be expenses that insurance does not cover.
A volatile stock market, sky-high income tax or capital gains rates and rampant inflation are other risks to your retirement income. But on the plus side, remember that retirees don't take all of their savings at once. Your money should continue to work for you, earning interest and dividends even as you start taking distributions.
Still, if Jamie is saving and investing diligently in her 401(k) for a good portion of her working years, her goal should be possible. You can use a retirement calculator like the Employee Benefit Research Institute's Ballpark E$timator or the fancy interactive retirement calculator at Merrill Lynch to see what is possible for you. With these calculators, you can change your assumptions to change the result. What if I saved 2% more per year, worked an extra year or two, and so on.
To be honest, using those calculators always scares me. The end result seems so unattainable, it's like I've failed before even trying. Creating a retirement number goal makes sense for some people, but for others, it's easier to contemplate saving say $200 a month or 6% to 10% of your annual salary (saving 18% is the goal that the Center for Retirement Research recommends). Some financial experts say aim to save at least 12 times your current salary. If you are just getting by financially, it's more important to save what you can than to aim for such an impossible number that you end up saving nothing.
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