How Much Money Do You Need to Retire?
April 01, 2010
MoneyRates.com puts a great deal of emphasis on helping you raise your personal savings rates and investing those savings in accounts offering high interest rates. Occasionally, though, it's worth taking a step back and looking at the big-picture goal of most of your efforts: retirement.
How Much Money Will You Need to Retire?
However diligently you save, it is important to have a goal in mind--some amount of money that you are building toward so you can afford a comfortable retirement. However, figuring out what that amount is can be somewhat complicated.
A recent survey by the Employee Benefit Research Institute found that most Americans have never calculated how much money they will need to afford retirement. While the calculation can be difficult, it is important to go through the exercise, because the answer may be more money than you think.
Inflation, Inflation, Inflation
The primary difficulty is that inflation makes retirement funding a moving target, and each generation's rule of thumb is already out of date when the next generation is ready to start saving. Adjusted for inflation, the amount of money needed to replicate today's standard of living is often surprisingly high.
For example, let's say you plan to retire in 40 years, and that $50,000 each year sounds like a decent level of retirement income to you. At a 3% inflation rate, the equivalent of today's $50,000 would be over $160,000 in 40 years. Funding that income level for 25 years of retirement--with inflation continuing to raise the income requirement through the retirement years--would require about $2.6 million at the start of your retirement in 40 years.
What You Need to Know to Answer the Question
You can adjust those numbers by lowering your income target or planning to work longer, among other things, but to do the calculation, you are going to need one of the following:
- A familiarity with financial concepts and spreadsheets
- Help from a reliable financial professional
- Some user-friendly financial planning software or a good Web-based retirement calculator
Whichever of the above methods you use, the most important things that go into your retirement planning are the assumptions. It's the old notion of garbage-in, garbage-out, and the assumptions that people use for financial planning are often off-base. Here are three critical assumptions to think about:
- Years in retirement. Knowing how much to save depends on knowing how long that money has to last, but don't simply use life expectancy as the basis for this assumption. For one thing, by the time you live to retirement age, your life expectancy at that point is going to be higher than the life expectancy for the general population (which takes into account the shorter lifespans of people who die young). For another thing, life expectancy figures are averages--you have a 50% chance of living longer than that, and if that's the case, your money will have to last longer.
- Inflation. Based on historical inflation, an assumption of 3% or 4% a year is reasonable.
- Investment return. This is where people often get carried away. Using a high return assumption can make retirement goals seem easier to meet, but it also increases your risk of failure. Assuming your retirement savings is in a mix of stocks, bonds, and cash equivalents, a realistic return assumption would probably be somewhere between 5% and 10%. The higher end of that range would be appropriate only if you had an aggressive asset mix and a very long time horizon before retirement. If you're unsure, it's safer to use more conservative assumptions and force personal savings rates to do more of the work.
You won't be able to accurately predict everything, of course, but by using conservative assumptions to come up with a retirement goal, you will be ahead of many other American workers--and more importantly, you will be building a solid foundation for the retirement planning process.
