For most people, retirement planning is the centerpiece of personal finance, the foundation on which all other monetary plans are built. Emergency fund balances rise and fall, and debts can be paid off later rather than sooner. But retirement planning has to be right from the beginning. Once it arrives, there won’t be time to fix it.
Determining how much income you’ll need in retirement
The simple method is to use 80% of your pre-retirement income as your projected retirement income. The percentage assumes that your living expenses will drop in retirement due to the absence of commuting expenses, certain payroll taxes (there are no FICA taxes on retirement and investment income) as well as the end of further retirement plan contributions.
As simple as that method may be, I’m not entirely certain it hits the mark. Retirees today are more active than they were a generation ago, and even though work related expenses will disappear, others will probably take their place. For example, retirees are now more likely to travel, to own second homes or to be welcoming “boomerang” kids back home. It may be necessary to have 100% of your pre-retirement income, or even more.
The best course is to use 80% of pre-retirement income as a starting point, then add in expected expenses or even those based on personal preferences.
Factoring in other income sources
Most likely, the income from your retirement plan won’t be your only income source. Some other possibilities include:
- Social Security income
- Pension income – if you’re covered by one
- Income from non-retirement investments, like real estate and non-tax-sheltered investments
- Any earned income you plan to have
You can deduct these sources from the amount of income you expect to need. But in doing so be cautious—people are living for decades into retirement and that means investment portfolios have to last longer.
The “Safe Withdrawal Rate”
Once you’ve determined how much income you’ll need, you next have to calculate how large of a retirement investment portfolio you’ll need to produce that income on a consistent basis.
Another popular convention in this regard is the safe withdrawal rate, generally held to be 4%. Based on long-term investment returns, it’s widely considered that a retiree can withdraw 4% of his or her portfolio each year for the entire duration of retirement and never go broke.
This is consistent with another rule of thumb that you should save 20 to 25 times your pre-retirement income. 25 times your income will provide for an annual withdrawal rate of 4% for 25 years. Investment returns will keep the retirement account from going down to zero. A person could retire at 65, live to 90, and still have money available.
Using a retirement calculator
Going forward to the next step, let’s say that you determine that you’ll need $60,000 per year–$5,000 per month—to live the retirement life that you want. You anticipate $20,000 per year from other income sources, so you’ll need your retirement plan to provide $40,000 per year. How big will your retirement portfolio need to be in order to provide that much income?
Using the safe withdrawal rate of 4% per year, an even $1 million will get the job done. How do you get from where you are now to a $1 million retirement portfolio? Simple, use a good retirement calculator.
For a 30 year old with a current income of $60,000, expecting to retire at 65, we can get to the $1 million dollar mark (actually $1,027,489) based on the following assumptions:
- An expected average annual rate of return on investments of 10% over 35 years
- Expected annual pay increases of 3%
- A 50% employer match, up to 6% contributions
Our 30 year old can reach that goal by contributing 3% of his or her annual income to the employer’s 401K plan. If that sounds too low, it’s because we aren’t quite done.
Don’t ignore inflation!
Inflation is the mortal enemy of retirement planning. The target number you set for your retirement portfolio today will be completely irrelevant when retirement comes. In our example, we’re looking at a 30 year old retiring in 35 years. That’s a long time for inflation to change all of the assumptions.
Though inflation needs to be factored into retirement planning, there’s no way to know with any certainty what it will be over the next 20, 30 or 40 years. Our best guess will be to look back at what it’s done in the past, and use that as a basis.
Our example is retiring in 35 years, so we need to estimate how large the investment portfolio will need to be at that time. We can make a reasonable estimate by using the Bureau of Labor Statistics (BLS) inflation calculator. If we go back 35 years—to 1977—we find that $1 million in 1977 would have to be worth $3,818,597 today in order to retain its original purchasing power. Projecting 35 years into the future, it’s likely that our example will need $3.8 million to retire, not $1 million!
Going back to the retirement calculator that means the 30 year old must contribute 14% of his pay into his retirement plan each year in order to reach the needed $3.8 millon, not the 3% we used before factoring in inflation. As I said, inflation is the mortal enemy of retirement planning.
Whether it’s inflation or some other factor, when it comes to retirement planning goals, you’re better off setting them high. If the worst happens you’ll be prepared for it. And if the worst doesn’t happen, you’ll be richer for the effort.