It’s difficult to know precisely what is required to retire with financial security. But it is possible to get a good estimate, which will then help in knowing how much to put away now to reach your goals. Here are five things to remember when determining how much you’ll need to retire:
1. Calculate the Income You Need in Retirement
When saving for retirement, you’re actually building an account value sufficient to replace 70-80% of your pre-retirement income. In different words, you need to replace your earned income with investment income, and other sources, such as a pension and Social Security. Estimating or calculating the income necessary to retire isn’t as difficult as it might seem. To estimate the money you need in retirement, you can start with your current income and make a few calculations:
The most simple calculation is to start with your current income, adjust it for inflation, then use 80% of that amount as a target retirement income. If you’re not a math wiz or you don’t know how to use a financial calculator, you can use the rule of 72 to figure your tax-adjusted income need (or you can simply use an online inflation calculator). With the rule of 72, you divide 72 by the rate and you get the number of years it takes to double the amount. 72 divided by an average inflation rate of 3 is 24. This means that in 24 years, the cost of living (and therefore your income need) will be twice as high as it is today. The best and most accurate estimate will likely be this online inflation calculator (the “forward flat rate” calculation). For example, I typed in $75,000 for today’s income and used a time frame of 20 years. The calculator says the future value (or future income needed in our retirement example) is about $135,000. Now we multiply $135,000 by 0.8 or 80% and we get $108,000—an estimate of how much a person or household earning $75,000 today will need about 20 to 30 years from now in retirement.
The 80% calculation, in case you are wondering, is a standard in financial planning that some advisors call the wage replacement ratio. Most retirees don’t need 100% of their pre-retirement income and 80% tends to be sufficient on average. If you want to be conservative, you might use 85% or 90% instead.
2. Get Estimates on Sources of Retirement (Other Than Investments)
Do you expect to have sources of income other than your savings? Although Social Security doesn’t seem reliable for some people, it’s not likely to go away. To be conservative, look at your Social Security statement and use the full retirement age for the calculations. Using our calculation example in the previous step, let’s say you estimate your Social Security earnings to be $20,000 per year. Now subtract that from your $108,000 estimate for income and you have $88,000 needed from investments or other sources. If you are fortunate enough to have more sources of income, such as a pension from your employer, you can do the same for that amount and subtract it from what you’ll need in retirement.
3. Use the “4% Rule” to Estimate How Investment Income Can Last 30 Years
The biggest risk to most retirees is not a crashing stock market but the risk of outliving their savings. Therefore, unless you have a family history of illness or cancer, you are wise to expect to live to age 90 or higher. How can you make your retirement income continue for at least 30 years? Another general guideline for retirement income is the 4% rule, which suggests a good beginning withdrawal rate for the first year of retirement is 4% of total retirement assets. From that point forward, you may increase the annual withdrawal amount by another 3% to accommodate inflation increases. Also remember another 4% amount, which is the annualized rate of return on investments you should average to make your money last for at least 30 years.
4. Determine How Much to Save to Reach Your Retirement Goal
Again, we can use some averages and general rules of thumb to arrive at a good estimate of how much money you should have put away prior to your transition into full retirement. If you don’t know how to use a financial calculator, your best bet is to use an online retirement calculator.
5. Don’t Worry, Be Happy
If you’re normal, you’ll discover you’re not saving enough money to sufficiently secure your retirement with your current savings. But all you can do is your best and the concern over your future financial security should not be cause for stress. If it’s any consolation, retirees often find themselves bored and unfulfilled without engaging in activities that are productive and interactive with other people. Guess what this describes—a job! You can work part-time to supplement your savings and Social Security income. But you don’t have to work in a stressful career and probably not more than 10-30 hours per week. At least 10 years in advance of your expected retirement, start considering lines of work that may not pay much but you enjoy. Or if you already like your current job, start planning for semi-retirement, where you work fewer hours. By doing something you enjoy, you won’t feel like you’re working. And with the extra time off, you’ll be able to slow down and do other things you may have missed previously in life, such as traveling or just taking an afternoon nap. The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
