Saving for retirement can be something of a Catch-22 — you’re saving money, and you keep saving money, because the goal isn’t always well-defined. That’s why you need to establish how much you really need in order to retire comfortably. Until you know what that number is, there’s really no way to know if you’re succeeding in your preparations, or if your plan needs more work.
So how do you determine what your retirement number really is? It seems that this figure is constantly changing, what with inflation rates, economic ups-and-downs, and the continued media hype.
In this post, we’ll cover each step, and keep a running example so that you’ll see how the numbers work.
Calculate Your Monthly Income
You can start with a number that’s close to home — how much you need to live comfortably right now.
Most financial experts recommend that you use something on the order of 80% of your current income to determine how much money you’ll need to live comfortably in retirement. I’m not sure how reliable such a number will be, but it’s a good starting point.
We’re going to keep this simple in our example, but it might be better if you are able to add or subtract for certain variables that are reasonably likely to play out between now and when you retire. For example, you could subtract if you plan to pay off your mortgage, or if you plan to move to an area that’s less expensive than where you live now. If you think your medical expenses will be higher (a very reasonable assumption), then you might want to add extra to your monthly income base to cover this expense.
For our ongoing example, let’s say that you earn $5,000 per month currently, from a full-time job or from your own business. By using 80% of that, we arrive at $4,000 per month.
Don’t Rely on What’s Predictable
Like most people, you’ll probably have one or more sources of supplemental income when you retire. Social Security will be an obvious source, but it could also be a defined-benefit pension plan payment, or even a large inheritance that you can convert into a regular monthly income.
You can get an estimate on your future Social Security benefits by using the Social Security Retirement Estimator. You’ll have to go through a number of steps, but the end result will be a reasonable estimate of the benefits you can expect to receive when you reach retirement.
Then deduct the expected amount of these income payments from your estimate of how much money you’ll need to live on.
For our example, let’s say that you can expect to receive $1,500 per month from Social Security. You can deduct this amount from your expected cost of living of $4,000, which will mean that you will still need to provide at least $2,500 per month from your retirement portfolio.
Apply the “Safe Withdrawal Rate”
Now it’s time to do a little math. There is a convention in retirement planning known as the safe withdrawal rate. It is the amount that you can withdraw from your retirement savings without ever depleting your portfolio. Under the safe withdrawal rate, you should be able to withdraw 4% of your portfolio each year, without your retirement plan ever running dry.
The theory is based on the fact that the historic rate of return in the stock market (since 1926) is somewhere between 8% and 10% per year. That being the case, if you limit your withdrawals to 4% of your portfolio, you will still have at least an additional 4% held in the portfolio to cover inflation, and keep the portfolio growing.
Applying the safe withdrawal rate of 4% to the amount of monthly income that you will need to be able to retire goes something like this:
$2,500 X 12 months = $30,000 (annual income) divided by .04 (the 4% safe withdrawal rate) = $750,000
$750,000 is the amount of money that you will need to have in your retirement portfolio by the time you reach your target retirement age.
Factor in Inflation
One of the biggest variables associated with retirement planning is inflation. If you don’t factor this into your retirement plans, you can end up with a retirement plan that is well short of what is needed to provide for you in your old age.
How do we calculate future inflation when we have no idea what it will be? We can make a reasonable guesstimate of future inflation based on past inflation.
Let’s say that you’re 40 years old, and you want to retire in 25 years when you turn 65. Using the Bureau of Labor Statistics’ Inflation Calculator, we can go back 25 years — to 1989 — to see what inflation has done to the value of the dollar in that time.
By entering one dollar as the value, and 1989 as the year, we find that it takes a $1.92 today to buy what $1 purchased in 1989.
Rounding $1.92 up to $2.00, we can reasonably assume that inflation will roughly double the amount of money that you need to have in your retirement portfolio by the time you retire. $750,000, based on the value of a dollar in 2014, will need to grow to $1.5 million in 25 years, in order to provide the same purchasing power.
Thus $1.5 million becomes the goal for how much money you will really need to retire comfortably.
Use a Retirement Calculator
Now that you know how much money you will need to retire comfortably — $1.5 million — the next step is to figure out how to reach the goal.
You’ll need to use a retirement calculator to help you with this calculation. Bankrate has an excellent retirement calculator for this purpose.
Conveniently, I’ve already calculated the numbers that will get you to the goal of $1.5 million, based on the following assumptions:
- Percent to contribute: 18%
- Annual salary: $50,000
- Annual salary increase: 2%
- Current age: 40
- Age of retirement: 65
- Current 401(k) balance: $50,000
- Annual rate of return: 9%
- Employer match: 50%
- Employer match ends: 6%
Based on these assumptions, you can reach a portfolio size of $1,528,912 by the time you reach age 65, by contributing 18% of your annual income to your employer’s 401(k) plan. That will bring you a little bit over the $1.5 million that we calculated you will need in order to be able to retire comfortably.
Once you establish a goal for your retirement portfolio size, getting there is mostly a math problem. Work up your number using circumstances and assumptions that are unique to your own situation.
Just make sure that you do establish a retirement goal, that way you know exactly where you’re heading, and what you have to do to get there.
Readers: have you calculated your retirement number recently?