Retirement planning involves looking into the future to figure out how much money you should save today. You also have to account for future inflation and your life expectancy. No one truly knows what inflation will be or how long they'll need their money to last. But you'll want to make the best estimate you can.
You can take certain retirement planning steps to help you plan as accurately as possible.
- It's best to think about both best-case and worst-case scenarios with the help of an online retirement calculator.
- Use the real rate of return in your planning. This is what you'll receive after the impact of factors such as inflation and taxes.
- It can help to redo and update your best-case and worst-case scenarios every few years because so many variables are involved.
Run Best- and Worst-Case Examples
Certain factors such as your rate of return on investments, your life expectancy, inflation, and your willingness to spend your principal will all have a giant impact on the amount of money you'll need to retire.
Develop best-case and worst-case examples to show the impact of these factors. The answers can be arrived at using spreadsheets and retirement planning software. An online retirement income calculator can help you run an analysis as well.
Inflation and Life Expectancy
Inflation is the measurement of what a dollar will buy at any given time. It's most often spoken about as it relates to the Consumer Price Index (CPI). The CPI is based on a standard basket of goods that economists decide nearly all people will need and must buy.
Inflation tends to run between 1.5% and 4% each year. Your dollar does not buy as much when inflation is high.
Life expectancy is the average number of years a person will live. Many factors are used to determine this number, including the area of the world in which you live and your socioeconomic level. The global life expectancy at birth for the entire population is 72.81 years, according to United Nations data.
A Best-Case Example
Let's assume that you need $50,000 per year to spend above and beyond your guaranteed sources of income. These sources would include funds from Social Security and Guaranteed Retirement Accounts (GRAs). The remaining best-case assumptions are a 2% inflation rate, 25-year life expectancy, a 7% inflation-adjusted return on investments, and a willingness to spend your principal down to nothing.
The software tells us that you will need almost $585,000 to provide this $50,000 per year of inflation-adjusted income for 25 years. An inflation-adjusted return, also known as the "real rate of return," removes the effect of inflation, taxes, and other expenses. It gives you an idea of what the return would be without the impact of external forces.
A Worst-Case Example
Again, let's assume that you need $50,000 per year above and beyond your guaranteed sources of income. The remaining worst-case assumptions are a 4% inflation rate, 35-year life expectancy, a 5% inflation-adjusted return on investments, and you want to retain $700,000 of principal to pass on to your heirs.
Now the software says that you will need nearly $950,000 to provide that same $50,000 per year of inflation-adjusted income for 35 years. Another big factor here is that you do not plan to spend your retirement funds down to zero. But this lets you pass what remains on to your beneficiaries.
A 35-year life expectancy isn't a bad thing. But it means a longer period of time for which you'll need to rely on your retirement money. Your savings are more likely to be stretched thin.
How Much Money Will You Need to Retire?
Retirement planning is not an exact science when you're trying to pin down how much you'll need in your total retirement savings. The answer in these examples is somewhere between $585,000 and $950,000. But you may need even more if life throws circumstances at you that are worse than the worst-case scenario.
You don't know what inflation will be when you retire, what your rate of return will be, or how long you'll live. You can't come up with an exact answer. The next best thing is to come up with a reasonable set of assumptions and make sure you re-evaluate every few years.
You may want to seek the help of a qualified retirement planner and do your own research to help nail down the right assumptions to use. You'll also want to factor in tax consequences.