Retirement Planning: How Much Will I Need?
There are several key tasks you need to complete before you can determine how large a nest egg you’ll need to fund your retirement. These include the following:
- Decide the age at which you want to retire.
- Decide the annual income you’ll need for your retirement years. It may be wise to estimate on the high end for this number. Generally speaking, it’s reasonable to assume you’ll need about 80% of your current annual salary in order to maintain your standard of living.
- Add the current market value of all your savings and investments.
- Determine a realistic annualized real rate of return (net of inflation) on your investments. Conservatively assume inflation will be 4% annually. A realistic rate of return would be 6% to 10%. Again, estimate on the low end to be on the safe side.
- If you have a company pension plan, obtain an estimate of its value from your plan provider.
- Estimate the value of your Social Security benefits.
A Sample Calculation
Before we begin with our sample calculation, a word about inflation. When drawing up your retirement plan, it’s simplest to express all your numbers in today’s dollars. Then, after you’ve determined your retirement needs (in today’s dollars), you can worry about converting the numbers into “tomorrow’s dollars,” i.e. factoring in inflation.
Just remember not to mix the two. If you do, your numbers won’t make any sense! After all, how do you contribute $300 in 2025 dollars each month to your retirement plan?
Compute all of your numbers in today’s dollars. When you are finished, you can apply an inflation assumption to get a realistic estimate of the dollar amounts you will be dealing with as you make your contributions over the decades.
Now on to the sample calculation. Consider the hypothetical case of John, a 40-year-old man currently earning $45,000 after taxes. Let’s go through the key factors for John:
- John wants to retire at age 65.
- John will need $40,000 of annual retirement income – in today’s dollars (i.e., not adjusted for inflation).
- John currently has $100,000 in savings and investments.
- Over 25 years of investment (age 40 to 65), John should realistically earn a 6% annualized real rate of return on his investments, net of inflation.
- John does not have a company pension plan.
- Visiting the SSA website, we can quickly calculate John’s estimated Social Security benefits in today’s dollars. Assuming John is born on today’s date 40 years ago and will retire 25 years from now, we can retrieve his estimated Social Security benefits in today’s dollars. The SSA website gives us a value of around $1,300 per month.
Now, John determined he would need $40,000 (in today’s dollars) annually to live during his retirement years. To the nearest $100, this works out to about $3,300 per month. Assuming John’s Social Security funds come through as estimated, we can subtract his estimated monthly benefits from his required monthly income amount.
This leaves him with $2,000 per month that he must fund on his own ($3,300 – $1,300 = $2,000), or $24,000 per year.
John is in good health and has a family history of longevity. He also wants to make sure he can pass along a sizable portion of wealth to his children. As a result, John wants to establish a nest egg large enough to enable him to live off of its investment returns – and not eat into his principal – during his retirement years.
Because John should be able to earn 6% annualized returns (net of inflation), he will need a nest egg of at least $400,000 ($24,000 / 0.06).
Of course, we haven’t accounted for the taxes John will pay on his investment income. If his capital gains and investment income is assumed to be taxed at 20%, he will need a nest egg of at least $500,000 to fund his retirement income, since a $500,000 retirement fund earning 6% real returns would produce income of $24,000 after 20% taxes. Consider, too, that any tax-deferred retirement assets will be taxed at his ordinary income tax rate, leaving him with even less disposable income.
Keep Inflation in Check
Now, keep in mind all these numbers are expressed in today’s dollars. Since we’re talking about a time period spanning several decades, we’ll need to consider the effects of inflation. In the United States, the federal government has kept inflation within a range of 2% to 4% for many years, and analysts project that it will remain within that range for a while. Therefore, assuming 4% annual inflation should keep your projections from falling short of your actual financial needs.
In John’s case, he needed a $500,000 (in today’s dollars) nest egg 25 years from now. To express this in the dollars of 25 years from now, we simply multiply $500,000 by 1.04, 25 times.
This is equal to 1.04 to the twenty-fifth power, multiplied by $500,000. So, we have:
- Nest Egg = $500,000 x 1.0425
- Nest Egg = $500,000 x 2.67
- Nest Egg = $1,332,900
As you can see, the $1.3 million dollar nest egg is a much larger number than the $500,000. This is because inflation causes purchasing power to erode over time and wage rates to increase each year. Twenty-five years from now, John won’t be spending $40,000 per year – he’ll be spending $106,600 ($40,000 x 2.67).
Either way, for the purposes of our retirement calculation, the inflation assumption doesn’t really matter. A $500,000 nest egg and a $40,000 budget expressed in today’s dollars is the same thing as a $1.3 million nest egg and a $106,600 budget 25 years from now, assuming inflation has run its course at 4% per year.
The key is that we assume that savings will grow at a real rate of return of 6% annually. The numbers would actually be growing at 10% annually, but inflation would be running at 4%, so the growth in purchasing power would actually be 6% per year.
You don’t need to worry about this too much for your retirement plan, but just keep inflation in mind when you determine how much you want to save for your nest egg every month. A $200 monthly contribution is nothing to sneeze at right now, but after 20 or 30 years, $200 won’t buy you very much. As you continue with your retirement plan year after year, simply check the inflation number each year and revise your contributions accordingly. Provided you do this, you should be able to grow your capital at your estimated real rate of return and reach your target nest egg.