One of the most frequently asked questions among those who are trying to plan for their futures is, “How much do I need to save for retirement?”
No doubt, this is an extremely important question because the answer will provide a foundation on which all aspects of your financial life can then be worked out. If you know the total amount you’ll need for retirement, you can make better decisions today about how much to save each month, and what to spend on major purchases such as a home, cars, etc.
As the saying goes, it’s much easier to eat the elephant by breaking it down into smaller chunks. Let’s face it, it’s tough to envision what our particular world will look like in 20, 30, or 40 years.
But I’m going to direct you to some very simple tools that will show you how to calculate your retirement income needs if you decide that you want to retire at age 65, for example. The process isn’t perfect, and it won’t replace the input of a good financial advisor who can work with you one-on-one, but it will get you in the ball park.
Key Retirement Variables
The best way to get a handle on your potential financial future is to examine your life right now. Do you like your lifestyle? Do you want to maintain the same or similar quality of life when you retire? Just between you and me, how much money do you really need to earn each year to live a reasonably comfortable life?
The reason I ask these questions, and want you to give them serious thought is because once you answer them, we can begin to bring your long term picture into better focus. Most people have a hard time figuring out how much they need to have saved because they don’t think their present life is closely tied to their future life. Trust me, there is a direct link. But I get why some people don’t see the connection. I was once 25 years old without a care in the world.
To help you determine how much money you’ll need down the road, I’m going to walk you through an example. And rather than send you off to find some random retirement calculator, I want you to understand the elements and logic that must go into your calculation. This way, it’ll stick. Let’s get started.
Let’s say that your good friend, Joe, is 33 years old and his current annual income is $50,000. Joe loves his existing lifestyle and would like for it to remain on the same level or close to it when he retires in 32 years (at age 65).
So the first thing Joe should do is visit the Social Security Administration (SSA) web site to use the official Life Expectancy Calculator. Here’s the link… http://www.ssa.gov/OACT/population/longevity.html
To use the calculator, Joe enters his gender and date of birth (March 6, 1980). Upon submitting this information, Joe is presented with the following life expectancy table:
The table provides an indication of how long Joe is expected to live. See the column labeled Estimated Total Years. The numbers in this column start at 81.5 and go up to 87.1. Basically, Joe is given more bonus time to live as he reaches certain milestone ages.
So, I added up all four numbers in that column (81.5 + 85.3 + 86.3 + 87.1= 340.2). Then I divided that total by four to get an average (340.2/4 = 85.05 years). Yeehaw, good old Joe is expected to hang around until age 85.
Now, if Joe retires at age 65 that means he’ll need a portfolio that will allow him to live comfortably for another 20 years, until age 85. Keep in mind that Joe wants to still have a $50,000 lifestyle for those years.
If you do the simple math, you might think that all Joe needs to have saved up is (20 years x $50,000 = $1,000,000). Sounds doable, right? Well, not so fast, my friend. We haven’t factored in the dreaded inflation factor.
Things get more expensive over time. For example, in 1980, the average cost of a new car was $7,200. But 33 years later in 2013, the average price ballooned to $30,700. Now that’s inflation! So how much will Joe have to pay for that same car when he retires in 32 years? A lot more than $30,700, that’s for sure. But doesn’t it blow your mind to think that the AVERAGE price of car could be well over $100,000 by then? Wow!
Anyway, the good news is that we don’t have to live in complete darkness to get a realistic idea of future prices for things. Over the last 50 years, the average rate of inflation in the United States has been around 4% per year. That number could be higher or lower as we go into the future, but it’s something we can work with now.
There are some additional variables that have to be considered as well, but I wanted you to understand the major ones first. They include time, income, life expectancy, and inflation. Now, let’s go a little deeper.
Use The “How Much to Save for Retirement Calculator”
For this next step, I’m going to employ the use of one of my favorite online calculators. You’re going to have to do some work too. I want you to jot down your current income or one that best matches your desired lifestyle. Then, choose an age that you want to retire. The norm is 65-67. Finally, visit the Social Security Administration (SSA) web site and calculate your life expectancy. Make note of it. For most people, it will be around 85 years.
Now, I want you to visit the following Pre-Retirement Calculator. I’ve populated it with Joe’s information. You should do the same after reading the detail explanation of each field below.
Definition of Calculator Fields
- Your current age – Self-Explanatory
- Current annual income – Self-Explanatory
- Spouse’s annual income – Self-Explanatory
- Current retirement savings – This is the grand total of all savings in your 401k, mutual funds, bonds, IRAs, etc. As you can see, Joe is not doing too well with only $10,000 saved up.
- Expected inflation – Use 4% since that’s been about the average over the last 50 years.
- Desired retirement age – Self-Explanatory
- Number of years of retirement income – This is the difference between your retirement and life expectancy ages. For example, 65-85=20.
- Income replacement at retirement (%) – How much of your retirement income will come from your investment portfolio? For example, if you anticipate having a part-time job during your retirement years, then you’ll withdraw less from your portfolio, thus lowering the percentage to something under 100%. If you dropped it to 80%, that would mean you plan on getting (20% x $50,000=$10,000) from another source.
- Pre-retirement investment return (%) – This is an estimate. It represents the average rate of return (or profit percentage) you’re getting on your pre-retirement investment portfolio. Over the last 100 years, the average rate of return on the stock market has been about 10% per year. Joes decided to enter 8% because as he gets closer to retirement age, he might shift a good chunk of his portfolio from risky stocks into bonds or other more conservative investments. His less risky investments will probably have a lower rate of return.
- Post-retirement investment return (%) – See above. This is the rate that your investment portfolio will likely earn during your retirement years. As mentioned, Joe will shift a large chunk of his portfolio to safer investments. So he entered 8%.
- Include Social Security benefits? – If you select “Yes”, the calculator will factor in the estimated dollar amount that you would get as part of your social security benefits when you retire. When you include this amount, it will mean that you could contribute less to your portfolio over the years and still meet your retirement goal. Joe selected “No” for the moment because he wants to see the results in case Social Security is not around in 32 years. He will go back later and rerun the calculator again with “Yes” selected just to see the difference.
- Marital status – Self-Explanatory
- Social Security override amount – If you’ve contacted the SSA directly and know exactly how much you can expect to get from Social Security, enter the amount here. Just be sure to select “Yes” under the “Include Social Security benefits?” field.
I would suggest that you rerun the calculator several times to address multiple plausible scenarios. For example, you could lower the inflation number to 3% since it has dropped over the last 10 years. Adjust the pre- and post- retirement percentages to slightly lower or higher. Run the calculator to include your estimated social security benefits.
If you find that there are two or three scenarios that speak to you at a gut level, take an average of all the results. Let that be the amount you carry around in your head and use as a goal. Be sure to save all the results and revisit the calculator at least every few years.
So now that I’ve covered how to use the calculator, let’s take a look at Joe’s results.
It’s clear that Joe has some work to do. If he wants to live a $50,000 per year lifestyle during retirement, he needs to have about $2.3 million in his investment portfolio by the time he reaches age 65. Because Joe didn’t save much money in his twenties, he has to increase his savings to at least $10,000 per year. This is why it’s important to start saving early. The longer you wait, the more you will have to contribute to get up to speed.
Additional Questions & Variables
As you contemplate the size of your retirement number, there are some things to keep in mind that could affect it. After all, we are talking about the future.
- A higher inflation rate (%) will increase the total dollar amount needed and a lower rate will reduce it.
- Assuming that Social Security and Medicare are still around when Joe retires, he will get a small supplemental income from the government. This could be used to make up for some or all of the short fall if he doesn’t reach the goal amount. If you want to get a more accurate estimate of how much you would receive in Social Security benefits, use this link… http://www.ssa.gov/estimator/. Personally, I think you should save money as if the government won’t be mailing you a check.
- Remember that even though Joe’s reported income at the moment is $50,000 per year, a good percentage of that represents contributions to his retirement portfolio. So he’s actually living a lifestyle that is below his income. That’s why it may make sense for you to perform the above calculation again using a lower income amount.
- When you retire, your home will most likely be paid for and (hopefully) your kids will be on their own. So you may not care about having the same lifestyle or doing the same activities as much as you do now.
- Your current income will probably rise over time, so you’ll be able to contribute more money toward your retirement fund. This may or may not result in you deciding to increase your desired lifestyle during retirement.
- If you’re not on pace to meet your goal, decide now how you want to handle it. Should you get a part-time job? Should you start a part-time business? Will you continue working beyond age 65?
- By the time you reach age 65, a large share of your retirement portfolio will be in conservative investments. They will probably still be earning enough to cover ongoing inflation and, perhaps, beyond that if the economy is good. This will be helpful if your pre-retirement portfolio falls short.
- If you decide to retire much earlier or much later than the typical retirement age, obviously that will have an impact on your total retirement needs.
- Taking on or carrying a large amount of debt later in life will have an adverse effect on your lifestyle.
I could go on and on. And you can play with different scenarios using the Life Expectancy and Retirement Calculators. The bottom-line is that you can now establish a baseline retirement amount to shoot for. But do your best to exceed it. If nothing else, I hope this exercise turns on some mental light bulbs and makes clear the importance of starting to save money now for the future.
Finally, if you come up with a retirement number that startles you, don’t fret. Remember that most of the money in your portfolio will come from the earnings (profits) on your consistent contributions and investments. The natural compounding of interest, dividends, and time will work to your favor, especially if you’re young. In other articles, we will discuss how to reach your goal in bite size chunks, such as showing you how much you need to save each month and where that money should go.