Foreword: This post will give insight to those who want a better understanding of their retirement needs. While there is no single answer to fit all situations; I will be discussing the different factors, strategies, and calculations to consider when planning for retirement. If you find yourself wondering if you are saving enough or whether you already have enough saved, read on!
Step 1: Identify retirement income needed
The income needed in retirement is the determining factor for how much you should have saved entering retirement. There are two primary methods you can take to identify your income need in retirement:
- The Top-Down Approach: This method is the simpler means to estimating future income needed, but also tends to yield a less accurate result. Most people who are many years from retirement use this as a quick estimation tool. This approach assumes you will want to maintain a similar standard of living to your pre-retirement days. Start by adjusting your pre-tax income by any estimated increase or decrease in expenses from entering retirement. A few examples of decreases: No longer making contributions to retirement plans, elimination of work expenses and FICA taxes, paying off the mortgage, etc. A few examples of increases: Increased vacationing, health care costs, leisure activities, etc. Once everything has been accounted for, this should leave you with an estimate for your annual expenses in retirement.
- The Bottom-Up Approach: This method tends to be the more accurate and time consuming way to assess future retirement income needed. To begin, construct a budget for current expenses. From there, examine each item on the budget to determine whether or not it will change in retirement. If you are unsure how to properly construct a budget, see our post on "How do I make a budget?".
Step 2: Adjust for inflation
The next step is to account for the inflation of your future retirement expenses. Most experts use the Consumer Price Index (CPI) as a benchmark to estimate inflation.
To account for the effects of inflation, use a financial calculator to determine the future value. For your convenience, I have linked one here. Just a quick example as to how this actually works: Let's say your estimated annual retirement expenses are $50,000 in today's dollars, you have 30 years until retirement, and you expect inflation to be average 3%.
Input $50,000 for the present value (PV), 30 years for the number of time periods (N), and 3% for the interest rate per time period (i). In this example, the estimated future value (FV) would equal $121,363. This means that when beginning retirement in 30 years, your estimated annual expenses will be $121,363 based upon the anticipated increase in the cost of living.
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Step 3: Determine lump sum needed
Next, identify how much of a lump sum would be required to successfully distribute that future income. This process will require the use of a full financial calculator and for us to make three assumptions:
- Expected rate of inflation: We assume that the cost of living will continue to increase as we make our way through retirement.
- Expected rate of return on investments: Investment return should be based on your tolerance for investment risk. Risk tolerance can be affected by many things such as age, personality, time horizon, etc. It is important to understand your tolerance for risk, which you can do by taking a risk tolerance questionnaire. It is very common for people to have a higher tolerance for risk when saving for retirement than when they are in retirement. For our example, we will assume a post-retirement expected return of 5% (Nominal Return).
- Expected life span in retirement: Life expectancy varies based on health, gender, and family history. The Social Security Administration has a simple calculator here based on broad statistical outcomes. For our example, if we assume expected retirement age is 65 and life expectancy is age 90, then there is a total of 25 years of expected life span in retirement.
For simplicity, I will continue from our previous example of a retirement need in today's dollars of $50,000.
To begin, we need to determine our inflation adjusted or "real" return (actual returns after accounting for inflation). To do this, we will use what is called the Fisher Equation. The Fisher Equation can be rearranged to look like the following:
Real Return = [(1+Nominal Return) / (1+ Inflation Rate)] - 1
So in our example, [(1 + .05) / (1 + .03)] - 1 = 0.029126 = 2.91% Real Return
Next, we need to grab or open an online version of a financial calculator. We will plug each number in to the financial calculator's corresponding tab. Our goal is to solve for the present value (PV) that is required to pay out $121,363 (PMT) per year for 25 years (N) assuming a 2.91% real return (i) and a remaining future value (FV) of 0. The payment will be made at the beginning of each period so the beginning or BEG button should be on.
FV = 0
N = 25
PMT = $121,363
i = 2.91%
When we click PV to solve for the present value we get $2,196,780.60. That is the future amount needed at retirement to successfully pay out $121,363 for 25 years.
You may have already done the math to figure that we are making our assumptions based on a 35 year old person (30 years to retirement at age 65). So the last question is, how much should you have in retirement savings to be on pace?
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Step 4: Determine present value of future lump sum
Let's assume that this 35 year old has an expected investment rate of return of 8% while saving for retirement. We can use that return to discount the lump sum to a current present value. To do this we will be making some quick calculations with the financial calculator again. This time we will assume that the future value (FV) is $2,196,780, the time to retirement (N) is 30 years, investment return is 8%, and to keep things simple we will assume they are not making any future contributions (PMT) towards retirement (unlikely, but easier to demonstrate).
FV = $2,196,780
N = 30
PMT = $0
i = 8%
Once we click PV to solve for present value, we get $218,310.14 as the current amount the 35 year old should have in retirement savings in order to reach the goal of $2,196,780 to pay out $121,363 in retirement ($50,000 in today's dollars). It should be re-iterated that it is unlikely a person in this situation would not make any contributions towards their retirement. For example, if that person were to contribute $5,500 per year then the present value needed would be reduced to $151,438.90. Notice how the contribution lowered what the present value needed to be today (i.e. the more you contribute, the less you need to have in a lump sum today).
Try your own numbers to see how you fare in your retirement goals. If you have questions or comments, you are welcome to reach out to me directly at firstname.lastname@example.org or (530) 272-1345.
Disclaimer: This is an informational guide. Nothing in this post should be interpreted as individualized advice. I have included several links in this post to give viewers a quick reference to the tools mentioned. I do not endorse any of the websites that I have linked nor has any compensation been paid for the inclusion of these links. I use an assumed rate of return of 8% pre-retirement and 5% post-retirement. These numbers are used for illustrative purposes only and actual returns cannot be guaranteed.
There are many things that can impact a retirement plan such as the sequence of returns, unexpected expenses, higher inflation, social security, pension income, etc. It is often best to work with a financial professional to construct your financial plan. You should always stress test a plan using simulation tools, which most financial professionals have available to them.