Probably the most common financial question we get from our clients is, “How much do I need to retire?” This is a real worry for most of us as we start approaching our retirement years.
Of course, it will be less of a worry the sooner we fully confront this question and start developing a plan to be ready when the time comes. Although there are many steps involved in determining how much you will actually need to accumulate by the time you retire and how much you need to set aside each month to accumulate it, it is pretty straight forward if you follow a logical step-by-step process. The purpose of this article is to take you through those steps.
For an even more in-depth analysis of answering this question for yourself, you can check out our “Master Retirement Course“. It’s full of 6 hours (and growing) of HD videos and a growing community of students. You can also ask us questions as you go through the course.
Where Do I Start?
The starting point to answering how much you will need to accumulate by the time you retire is to determine your best estimate as to how much income you will need each month during your retirement years.
In order to do this, you need to develop some sort of budget. There are two ways to approach this issue: you can create a brand new budget starting from the ground up, or you can start with your current pre-retirement budget and make the adjustments necessary in order to more accurately match your post-retirement income and your most likely post-retirement spending. This whole exercise depends on you taking some extra time now to come up with a realistic budget and a meaningful and workable plan.
What are Your Retirement Income Needs?
Most financial people point out that some of your post-retirement expenses will go down. This is true in some cases, but keep in mind that many of your post-retirement expenses might actually increase.
For example, you might have to start paying for Medicare Part B premiums, or supplemental insurance premiums. Or perhaps your employer or your spouse’s employer has paid all or a significant part of your health insurance premiums until retirement, but now you might need to pick up the tab for your own insurance. This is particularly important when you plan to retire before the age you can begin Medicare coverage, which is currently age 65.
Additionally, the amount spent on travel and entertainment (like going to plays, movies or concerts) will most likely increase as you have more free time available. This could be the case even though a certain amount can be reduced by taking advantage of senior discounts. Travel expenses certainly may increase—as you have earned the right to spend your retirement traveling and taking time you couldn’t during you working years.
Your medical expenses (especially prescriptions), long-term care, dental work and vision care might go up substantially—they certainly do for many of our clients.
Be sure to also consider your adult children whom may end up needing financial assistance—many times following a divorce, early death of a spouse, or loss of a job. Don’t forget you also might be providing financial assistance for your grandchildren, including their education as well. The lesson here is, you should always account for those unexpected expenses—making sure to do the best job you can now with the information you have.
Some of your expenses such as clothing, laundry and dry cleaning, gasoline and other commuting related expenses will decrease in your post retirement years. Many retirees find their spending decreases because they keep their automobile longer or they reduce the number of cars they own or lease from two or three down to only one or two.
In some cases, the additional free time which retirement affords can be used for doing chores around the home such as lawn care, pool care, house cleaning, etc., thus saving the amounts you paid for these services while you were employed.
In most cases, what we see is that costs tend to go up in the early part of retirement, then later they start to decrease. Sometimes they start to rise again rather dramatically due to higher medical and long-term care costs. You need to be aware of these changes in your lifestyle and make plans for the costs appropriately.
What about Inflation?
You also should be sure to consider the effects of inflation on both your income and expenses. A simple way to do this is to solve for your monthly shortage (income needs at retirement minus anticipated income during retirement), which will need to be funded from your retirement and other savings accounts. Use an inflation calculator to arrive at an adjusted income which will be required starting at the time you actually plan to retire. Of course, most likely this number will continue to increase along with inflation throughout your retirement years. Again, using the proper inflation calculator you can allow for these adjustments.
Al & Betty at Retirement
Let’s look at an actual example using the calculations mentioned above. Let’s assume Al and Betty are 58 years old and they plan to retire at the age of 69. So we know they have 11 years before their retirement.
Let’s assume currently they earn $84,000 per year, and after careful consideration they have determined their post-retirement budget will require an annual income of $78,000, or $6,500 per month. After looking at life expectancy tables, considering their health status and reviewing their family’s longevity, they figure and plan that they most likely will live another 20 years after they retire.
Neither Al nor Betty have any pension or other retirement income, but they do have Al’s 401(k) account through his employer. Betty was a stay-at-home mother and wife—and she was very good at her job.
According to the Social Security Administration, their total monthly Social Security income is estimated to be $3,375 at the time of their retirement. This means they will have to make up the shortage in the amount of $3,125 ($6,500 less $3,375) per month from AL’s IRA account, which will be rolled over from Al’s 401(k) to a traditional IRA account at the time of his retirement.
In the first example below, Exhibit 1, we solve for the amount Al and Betty will need to have at the beginning of their retirement (in eleven years) based on an assumption that they will need to withdraw $3,125 per month for twenty years (their life expectancy.) Remember that they will need to withdraw that $3,125 from their retirement account each month.
In our example, we have assumed they will be able to earn an average of 10% per year in the account during their twenty years of retirement. Once you have a self-directed IRA, and the proper investing knowledge, we believe 10% to be a conservative number.
As we can see, based on this calculation they will need to accumulate almost $334,000 in their retirement account by the time they are ready to retire.
What’s the Shortage Today?
The balance of Al’s 401(k) account is currently $86,000, and he is planning to continue to fund his account by contributing 6% of his monthly pay. This currently amounts to a monthly contribution of $420, and he expects to earn an average annual rate of return of 8% (an average high growth rate for a 401(k)).
Based on these assumptions, as Exhibit 2 shows above, his 401(k) balance will be about $287,450 when he is ready to retire.
When we compare this amount to the amount required from Exhibit 1 above, we see that there is a shortage in the amount of $46,550—which is the difference between the amount they expect to have in his account in eleven years ($287,450) and the amount they expect to need to fund their retirement ($334,000).
Now, in Exhibit 3 below, let’s consider that Al will continue to contribute the same $420 each month to his 401(k) account but instead of earning an average annual rate of return of 8%, he is able to earn 9.7%.
If we solve for the future value of the retirement account we see that he can expect to have $334,022 in his account by the time he retires. Comparing this number to the amount required ($334,000)—see Exhibit 1—we can see that Al and Betty should have enough to support their needs for the twenty years of their retirement.
Another way to address this shortage we calculated in Exhibit 2, is to assume that Al cannot increase his rate of return beyond the 8% he was originally expecting, but he is able to increase his monthly contribution for the 11 years by $225 per month from $420 up to $645.
As we can see in Exhibit 4, this will result in an expected account value of $334,015 which is also enough to cover the shortage calculated in Exhibit 2.
Additional Options to Cover the Shortage
There are still more ways for Al & Betty to cover their shortage. For example, Al could retire one year later, which would increase his social security income by 8%, decrease the total number of years in retirement to 19 years, and add another year of contributions to his 401(k).
They could also get a larger return on their money in retirement—beyond the 10% assumed. This is a fair assumption, provided Al and/or Betty learn more about investment options.
Another option is for Al and/or Betty to turn one of their hobbies, talents or interests into a cash-generating business during Al’s continued employment, or after he retires. This would increase the amount they could continue to set aside in their retirement account. If this money was being earned into their retirement years, then the result would be a decrease in the amount they would need to withdraw each month. This will allow them to later increase their retirement income as well.
The point is, they have many options available to them in order to fund their retirement. They now have a plan and they know they will be able to take care of themselves. They have hope for their future; we hope you’ll see that there is hope for yours as well.
Will You Have Enough at Retirement?
In going through this exercise, we can see that there are different approaches to solving the retirement puzzle. We also see how important it is to address the issue sooner as opposed to later. You have more options and strategies available if you start to tackle the problem now—as opposed to 5, 10 and 15 years from now.
It all begins with taking inventory of where you are now, and determining what you need to accumulate in order to have the retirement you want to have. All of it can be done with the proper planning. You should always remember that there are options if you find yourself with a big shortage that seems insurmountable. You can increase returns, you can find ways to make more money or save more money, and fill that gap.
Of course, we are making a few assumptions in these calculations, but that’s all we have to work with. We have to use our best efforts and the best information available. Probably the most important take-away from this article is the importance of having a plan—one that will work and that you can understand. These plans can be revised and tweaked as you move forward. Happy Retirement!
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