3 steps to create a more realistic retirement savings plan

Retirement planning isn't easy, but spending your later years in poverty is even harder. Considering that choice, people would do well to get down to the details of retirement planning as soon as possible.

What's so hard about that? The process itself is difficult because there are so many variables. Fortunately, there are a number of retirement calculators available that can help you account for these factors, but coming up with the right numbers is trickier than it might seem. Like many things, retirement planning is a garbage-in, garbage-out process, so getting those variables right is essential.

Here are three steps to help you set up your retirement savings targets the right way:

Step 1: Estimate a retirement budget

You may come across rules of thumb for estimating your retirement income needs based on a percentage of your pre-retirement income. The best advice is to ignore these rules because they ignore two key variables:

1. How much of your pre-retirement income do you spend?

Two people may have the same income, say $80,000 a year. However, if their lifestyles are such that one spends every penny, while the other spends half as much, obviously the higher-spending lifestyle is going to take more retirement savings to support.

2. How much debt do you have?

Imagine these two scenarios: 1. Going into retirement debt-free, including a paid-off mortgage, or 2. entering retirement with a heavy dose of credit card debt and several years of mortgage payments left. Even with the same lifestyle in terms of current consumption, the high-debt scenario would require a higher retirement income.

Rather than relying on a simplistic rule of thumb, the best way to estimate a retirement budget is to build it from the ground up. Start by listing your current expenditures, and then examine the list to determine what would be different in retirement.

Step 2: Project total retirement needs

Your retirement budget is a starting point, but then you have to project the amount in your savings account you will need for your income throughout your retirement years. In this case, the trickiest variables are:

1. Inflation

Rising costs mean it is likely to take much more money to support a given life style in the future than it does now, and how much more depends in part on the rate of inflation. Don't be lulled by temporary periods of low inflation.

For example, for the five years ending Dec. 31, 2015, inflation had averaged just 1.53 percent per year. However, over a 50-year time period, it had averaged 4.09 percent annually. How much difference would a few percentage points make? In 30 years at a 1.53 percent inflation rate, it would take $78,966 to buy the equivalent of what $50,000 would buy today. At 4.09 percent, it would take $166,663, or more than twice as much. Use a realistic, long-term inflation assumption in projecting your retirement income needs.

2. Longevity

While it is impossible for you to guess how many years you will live in retirement, your longevity determines a key component of retirement planning. How many years of retirement income will you have to fund? The ideal is to build up a big enough nest egg so you can live off investment returns without drawing it down, but this is unrealistic for many people. Failing that though, the more years you plan on living, the more you can reduce the chance of outliving your savings.

Step 3: Choose realistic return assumptions

Looking at your income needs and projecting them into the future gives you a savings target and hitting that target depends on how much you save and how much your investments earn.

Aggressive vs. lower return assumptions

The more your investments earn, the less you need to add to your nest egg via savings. That's why it is popular to use fairly aggressive investment return assumptions because it makes building retirement savings seem easier. However, this also increases the risk that actual returns will fall short of assumptions, leaving your retirement savings short of your target. Especially in an economic environment featuring low interest rates and slow growth, the more prudent approach is to use lower return assumptions, and face up to the need to save more from the start.

As you can see, none of the variables involved is cut-and-dried, but if you reason through them step by step, you can devise retirement savings targets more accurately.

These planning steps are just part of what is tough about retirement savings. The next challenge is having the discipline to follow through on your plan - and that part is entirely up to you.

Comment: How are you creating your retirement savings plan? What factors do you account for?

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