While there are countless generic retirement calculators available on line, there are several serious limitations to them from a planning standpoint. First, knowing how much money you will need for retirement is uniquely personal and specific to you and your circumstances, and there is no one size fits all tool to determine your needs. Second, and more problematic, there is simply no crystal ball that exists to predict the future. How much will you earn between now and retirement? How much will you be able to save? How much will I really need when I retire? What annual inflation rate should I assume before and after retirement? Will Social Security even exit to help defray my living expenses? What might happen between now and retirement to derail my plans?
Yes, there at lots of things we just don’t know and can’t completely plan for, and that is just the nature of life. But, perhaps the best we can hope for is to make some basic assumptions and at least get started on a plan. As with a business plan, a personal retirement plan works best when it is first created, and then modified each year to meet changing circumstances and the twists and turns life brings to us all.
So let’s get started with some homework you should do before any calculations are made.
How much money do you make today?
Your current income is a logical starting point for calculating your retirement planning savings needs. Generally, the more you make today, the more savings you'll need for retirement to keep pace with the lifestyle you will be accustomed to at the point you retire. For most of us, the incomes we earn when starting out, and the lifestyles we lead, are far more humble than those later in life. When you retire, you want to maintain the last and/or best lifestyle you have grown accustomed to if at all possible.
When do you want to retire?
If you wait longer until retirement, not only will you be retired for a shorter amount of time, but you will also work more years, meaning you can save more before you do finally retire. Conversely, the younger you are when you retire, the longer you can expect to live during retirement and the more you need to have saved beforehand. In addition, the effects of inflation can severely impact retiring too early, or even retiring then maintaining your lifestyle.
What do you want to do once you retire?
What do you envision for your retirement years? Does your vision of life in retirement look like the one you have now with more spare time, or do you dream to do all the things you were not able to do during your working years, like travel to exotic places, own a vacation home on the lake, or perhaps buy an RV and travel the country? Conversely, perhaps you fancy the idea of an early retirement in exchange for a lower standard of living. There is no right or wrong answer to this of course, but understanding your desired retirement lifestyle is an essential element in answering the "How much savings will I need?" question.
How much will you collect from Social Security?
Most financial planners will calculate retirement needs assuming that monthly social security payments will defray living needs in retirement. Expected future benefit payments are available annually from the Social Security Administration and are based on your lifetime earnings to date. Personally, if you are currently under 50 years old, I would not count on the social security income in retirement. In fact, as a practicing CPA and money manager, I have advised my clients for the last 30 years NOT to count on social security as we planned for retirement. Believe me, I do hope it is there for you and me, but I consider it only icing on the cake at best, and simply would not count on it being there the rest of my life. One needs only look at massive budget deficits and the political landscape today to see just how possible the reduction or elimination of social security is more than possible.
Will you receive any 401(K), IRA, or other pension benefits during retirement?
If you contribute to an IRA or your employer 401(K) plan, or if you are covered under another type of pension plan, then congratulations and do continue funding as much as possible where you can do so. These plans not only defer taxes, but increase the amount of money you will have available to meet your living needs during retirement. Calculate your expected retirement benefit from these plans when calculating the amount of savings you will need to provide to meet your living needs.
How do you invest?
During your working years, to the point of your retirement, how you invest will help determine what you might be able to accumulate towards your retirement nest egg. Historically, if you invested more aggressively over 20 years or more, you would reasonably expect a higher rate of return on your investments as compared to investing more conservatively. That would mean you would have had to save less money compared to another individual who insisted on keeping all investments safe but low return types of portfolios or bank accounts. Having said that, the truth of the matter is that the last decade has produced a very volatile stock market, and when measured by the S&P 500, returns have been flat to down during this time frame. However, a mix of small cap, international and emerging markets investments, along with a proper balance of fixed income, has actually produced reasonable results. The point is then, that traditional thought of investing aggressively in large cap US stocks has not provided superior returns, while a well diversified multiple asset class portfolio has, with less risk to boot. Therefore, getting some very good advice on how to construct your portfolio for retirement is critical.
How old are you now, and how much have you saved already?
The younger you are and the more you save, the less you'll need to save in the future in order to achieve the same retirement standard of living as someone older or with less money saved up until this point. Unfortunately, many cannot start a significant savings program until the kids are out of college and on their own. Waiting too long is of course a real disadvantage, but not impossible. If you are ten to fifteen years to retirement and still have not amassed any savings, it’s not too late, but you must start now in a serious way.
Up to this point, the above items can reasonably be determined and are based on your personal facts and circumstances. Just recognize that over time, these too will change and that is why you should review your retirement plan at least annually.
Now for any of the online calculators used for retirement planning, there are several numbers you must enter that we cannot possibly know with certainty. Again, annual updates will help to smooth out changes in the economy, markets, or personal circumstances to help you stay on track.
Unknown number 1 – the rate of Inflation
For the last decade or so, we have enjoyed a very low rate of inflation, but it has not always been that way. During the 1980s and other periods in our history, the rate of inflation has been very high. Currently, inflation is running about 3.5% per year. The government publishes several inflation indexes, the most popular known as the consumer price index (CPI). The CPI is often reported as the “core rate” which excludes food and oil. Personally, since I use food and oil to a large extent in my daily life, I prefer the CPI “Headline” rate of inflation, which includes food and oil. It is usually a much higher number than the core rate, but a much better reflection of real inflation. The CPI rates are available on line monthly. Many believe that the inflation rate will spike up in the next few years, due to the massive spending and money printing policies to stimulate the economy. The higher the rate of inflation you use, the more conservative your retirement savings calculations will be. At a minimum, use the current headline rate, but make sure to update annually. Don’t underestimate the rate of inflation issue. You may be shocked to learn that the amount of money you need to live on today will likely be a much higher number 20 or 30 years from now. For example at the current rates of inflation, if you spend $40,000 per year today, you will need $113,000 per year in 25 to 30 years just to maintain the same standard of living. While many planners also assume that you will need less than your current income when you retire (75% to 80% of your current income), I do not subscribe to this theory. Most of my clients are spending as much or more during retirement, not less.
Unknown number 2 – the rate of return on investments
All retirement calculators require you to enter an assumed rate of return on your investments between now and the date you expect to retire. The truth is, the brightest minds in the country have no way of knowing this any more than you or I do. They just sound really confident when they guess. Up until the early part of this decade, most financial planners assumed the average rate of return on the S&P 500 (the stock market) would be about 11%. At least that is what is was from the depression forward. If you look at the last 10 years or so however, the S&P has been flat – no return at all. If we couple that with the fact that long term treasury bonds are only paying under 3% right now, it would appear that returns will be muted in the short term. Again, a balanced portfolio of many asset classes, global and domestic, is the approach we take to balance returns and risk. In addition, the older we get, less money should be allocated to stocks and equities, and more to fixed income to control risk. For now, an estimated return on investments should be a more reasonable number, such as 6% or less for a conservative investor.
Unknown number 3 – the “safe” withdrawal rate
The withdrawal rate is the annual percentage of money you would expect to be able to take from your investment portfolio during retirement, and never run out. Ten years ago, most planners used an annual withdrawal rate of 5%, but that was when market returns were much higher. I would suggest an annual withdrawal rate today, of 3.5% to 4% per year to be safe. The worst possible outcome would be to run out of money during retirement, so I tend to lean conservatively on the withdrawal rate.
In conclusion, you can see that there is no one size fits all way to plan for retirement. The earlier you start this process however, the greater chance of success in saving enough to retire comfortably.
Anthony Caruso, CPA has practiced as a certified public accountant and investment advisor for over 30 years. Caruso and Company, P.A. is a Registered Investment Advisor offering fee based money management, tax and financial planning.