Everywhere you turn, it seems that somebody is telling you about your horrible retirement prospects. Expert after expert warns that Social Security won’t be around as long as you are; that your company pension — if you have one — will prove inadequate; and that Americans, in general, and you, in particular, are not saving enough to pick up the slack. Nobody wants to be poor when they’re old. (Most people don’t even want to be old, but I can’t help there.) As a result, saving for retirement has become America’s top – and most vexing — financial goal.
But how do you know how much to save or when you’ve saved enough? How do you balance the incessant financial demands of everyday life with the need to handle a potentially gigantic long-term obligation? It’s not as hard as it sounds. You just need to take it one step at a time.
Step One: Determine what you’ll need
Before you can figure out how much to save for retirement, you need to know what you’re going to spend in retirement. How do you do that? You create an estimated retirement budget.
Start with your current monthly budget — the amount you currently spend on food, clothing, entertainment, travel, housing, utilities, insurance, taxes, etc. And then hypothesize about how this budget is likely to change after you’ve stopped working.
Presumably, you’ll no longer be paying into savings. Hopefully, your kids will have already graduated from college and won’t be asking for regular support. If you expect to have paid off your mortgage, you can scratch off that big obligation of the budget too. But you may spend more on travel, entertainment and, possibly medical care. Give it all your best guess and come up with a number. Jot it down. This is your estimated monthly budget in retirement.
Step Two: Examine your resources
Where is that money going to come from? Most likely from a combination of sources that may include Social Security, a company pension, an inheritance and your own savings. You only need to save for the “gap” that’s not covered by those other sources of income.
So your mission is to come up with your best guess on that gap. You can estimate your Social Security income at SocSec.gov. This government site estimates your retirement benefit by assuming you’ll continue to make about what you earn now and then gives three numbers — the monthly benefit you’ll receive if you retire early; what you’ll get if you retire at your “full retirement age” (which varies based on your year of birth); and the amount you’ll get if you wait to receive benefits until age 70. Again, give it your best guess. Retirement planning isn’t precise. You should actually do it every few years as things in your life change in ways that affect your assumptions. If you have a pension, get an estimate of the benefit from your pension administrator, too. (We’ll talk about your savings and inheritances in later steps.)
Add those up and compare the result to the monthly amount that you’ll need. If your resources are more than adequate to cover your estimated expenses, pat yourself on the back. Congratulations, you’re done. Stop reading. Really. Go to the “garden” page. Or go brag to your friends. You are fine. The horror stories do not apply to you, lucky. Check in again in a few years, if anything changes. Otherwise, shoo. You’re making the rest of us feel inadequate.
Everybody else go on to Step Three.
Step Three: Take a look at your savings
Since knocking off rich relatives will land you in prison, you should plan on filling that gap with savings. (Sure, somebody might eventually leave you some dough. But, your relatives will like you a lot more if you don’t bank on that. It’s a little creepy.) So now the question becomes: How much savings do you have now; what will that be worth when you retire; and how much more are you likely to need?
Let’s start with what your current savings will be worth at retirement. Through the magic of internet calculators, you can plug in your current savings into something like BankRate.com’s “simple savings calculator” and it will spit back a future value. You just need to put your current savings on the first line; how much you’re adding to savings each month now; the number of years to retirement; and an estimated interest rate. (The site’s default rate of return is 6.5% and, if you invest in a diversified portfolio of stocks and bonds — as you should for a long-term goal like retirement — you’ll probably earn more. But use that default rate or an even lower rate — like 5% or 6% — anyway. Why? It will give you an inflation-adjusted number, which saves you from having to inflation-adjust your monthly retirement budget. Inflation typically averages 2% to 3% per year; a diversified portfolio returns about 8.5% to 9.5% per year. So, if you assume your investment return is 9.5% and inflation is 3%, a good inflation-adjusted return would be 9.5% minus 3% = 6.5%.)
Hit “calculate.” Voila! The site will spit back the amount you are likely to have in savings at retirement, based on what you have now and your current savings rate.
Step Four: Multiply
Take a look at the result in Step Three and multiply the number you came up with by 4%. Why 4%? Because that’s rule of thumb for how much of your retirement savings you can tap in year one without running out of money, assuming you maintain the same annual withdrawal amount with only slight differences to adjust for inflation.
So let’s say that the BankRate calculator says your current savings will be worth $500,000 in 20 years when you want to retire. You multiply by 4% and find you can safely withdraw $20,000 per year, or $1,667 per month from savings.
Compare that to the gap you calculated in Step Two. More than enough? Cool. You’re done. Go away. Play. Enjoy yourself. You’re good.
Not enough? Go to Step Five.
Step Five: Do a little more math
Take the remaining savings gap that you calculated in Step Four and multiply by 300. That’s the amount of additional savings you’ll need by retirement, assuming still that you’re tapping just 4% of your savings each year. So, if your monthly shortfall was $1,000, you’d see that you need $300,000 in additional savings before you retire.
How much must you save monthly to get that amount? Multiply the result by the multiplier in the chart here that best matches the number of years you have until retirement and the inflation-adjusted return you expect to earn. Thus, if you’ve got 15 years to go until retirement and figure you’ll earn a 6% inflation adjusted return, you’d multiply your gap by .0034. If your gap was $300,000, for example, that would tell you that you need to save about $1,020 per month more to hit your goal. ($300,000 x .0034 = $1,020.)
Step Six: Wait and repeat
The one last thing to remember is that life is fluid. Retirement planning should
be too. Over time, life will change. You might make a killing in the stock market;
start a company and earn — or lose — a fortune; have a personal epiphany and
adjust your dreams. No one can predict the future. But big changes alter your
retirement math, so do this again in a few years to make sure you’re still on track.
Valuable resources elsewhere on the web:
Life Expectancy Calculator: If you just knew how long you would live, you could plan your finances to spend your last penny on the day you died. Unfortunately, lifespans are not guaranteed. But longevity is reasonably predictable — or so say researchers at Pennsylvania’s Wharton school, which pulled data from AARP and the National Institute of Health. You can play with this longevity tool published by Time to get a rough idea of how long you may live and why.
Kiplinger’s Retirement Calculator: There are a million calculators that aim to help you figure out how much to save, but many of them are sponsored by money management companies that have a vested interest in over-estimating what you need. This is the retirement calculator I like best. It still asks to estimate what percentage of today’s income you’ll spend in retirement. But it allows you to plug in whether you’ll use home equity and whether you have other sources of pension income in addition to Social Security. That’s surprisingly rare. And, of course, Kiplinger has no vested interest in how much you save.
And for a little fun….check out Donna Freedman’s piece: Want a Chance at a Decent Retirement? Have a Daughter.