By JLP | April 20, 2008
The other day I asked the following questions in a “Question of the Day” post:
In your opinion, what’s the most confusing aspect of personal finance?
What area gives you the most trouble?
Several commenters stated that they had problems with trying to determine how much they needed to save for retirement.
That’s a tough question for a variety of reasons:
1. Retirement may be decades away. AS quickly as things change from one day to the next, it’s extremely difficult to imagine what the future will be like decades away.
2. Nobody knows what inflation will be like over the next few decades. A gallon of milk is around $4 today. At an inflation rate or 3%, that same gallon of milk will cost over $7 twenty years from now.
3. Expected rates of return are hard to determine. If you’re too conservative and use a lower expected rate of return, your calculations will tell you that you need to save lots more. On the other hand, if you’re too liberal and expect a rate of return that’s too high, your calculations will tell you need to save too little.
4. Nobody knows how long retirement will last. It could be five years or it could be forty years.
5. What will happen with Social Security? Although I’m not expecting Social Security to vanish, I do expect to have to wait longer to get a REDUCED benefit. It stinks, but I don’t see any way around it. That’s why I don’t include Social Security in my retirement analysis. If I get some, great. If not, I’ll be ticked, but I’m at least prepared.
6. Nobody knows what taxes will be like in the future. If I were a betting man, I would say that tax rates will be higher in the future.
7. It’s hard to balance today’s needs with the needs of the future. Let’s face it, we all want to enjoy life today without sacrificing the future.
So, where do we start?
Personally, I think the place to start is by looking at your current situation. Ask yourself these questions:
Do I make enough today to provide for all my needs?
Realistically, how much more do I need to make in order to put myself financially comfortable situation?
I use the word “realistically” because we would all like to make $1 million per year. However, for most of us that just isn’t realistic.
If the answer to the first question is yes, then take that number and project it into the future using an expected inflation rate. For example: say your current taxable income is $75,000 per year. We’ll assume that you are happy with that number and feel that you could have a comfortable retirement on $75,000 per year (in today’s dollars and excluding Social Security).
The next step is to then look at a range of possible inflation rates to get an idea of what amount will equal $75,000 in today’s dollars sometime in the future. For instance, let’s say you are 30 years from retirement and expect inflation to run between 3% – 4% over the next 30 years. Using the future value formula, we can calculate the future value of $75,000 at both 3% and 4% inflation rates like this:
At 3% inflation…
FV = $75,000 × (1 + .03)30
FV = $75,000 × (1.03)30
FV = $75,000 × 2.427262471
FV = $182,045
At 4% inflation…
FV = $75,000 × (1 + .04)30
FV = $75,000 × (1.04)30
FV = $75,000 × 3.24339751
FV = $243,255
It’s seems crazy to think that someday it will take $182,045 just to equal what $75,000 buys today. That’s inflation for ya! Anyway, according to those numbers, we are looking at a range of $182,045 and $243,255.
So, we have an idea of our future income needs. Now we need to figure how big of an account we need in order to generate that kind of income. There’s a couple of ways to do this. The first one assumes that you don’t want to touch your capital base so that it can hopefully grow each year, giving you a bigger base with which to withdraw from in the future. This is the most conservative method. It’s also going to require A LOT more money.
Here’s how it works. Let’s assume that you don’t want to withdraw no more than 4% to 5% per year. You simply divide your withdrawal rate into your income needs to get your capital base. Like this:
$182,045 ÷ .04 = $4,551,117
$182,045 ÷ .05 = $3,640,894
$243,255 ÷ .04 = $6,081,370
$243,255 ÷ .05 = $4,865,096
So we’re looking at needing a capital base of $4.5 million to $6 million if you don’t want to withdraw no more than 4% per year. Theoretically, as long as your portfolio returns more than 4% per year, you shouldn’t run out of money (assuming you don’t withdraw more than 4% of your portfolio’s value). It also means that you will have a pretty good chance of being able to leave an estate to your heirs if that’s important to you.
Another method is to use the retirement savings calculator I put together a couple of years ago. I had forgotten that I had created this calculator until I found it while looking through my Excel spreadsheets. This calculator is one of my favorites because it was one of the most challenging to create.
The calculator is composed of two parts: the input page and the print out page. Both pages work hand-in-hand. Using the numbers from above, we can input the following information:
Current Age: 35
Retirement Age: 65
Expected Length of Retirement: 25 (in other words, you expect to die at 90)
Current Income: 75000
Desired Assets to Leave to Relatives/Charity: 250000
Amount Currently Saved: 100000
All the other blanks should already be filled in for you. You can, however, make changes and run different scenarios. For instance, if you didn’t want to leave anything to charity, you could put 0 in that blank. I would recommend against this because the amount in that box could be your safety net in case you live longer than 25 years in retirement.
Anyway, this calculator tells you that you need a little over $3 million at age 65. Why is this amount so much smaller than amounts we found previously? Because this calculator assumes that you are spending down your principal during retirement. IMPORTANT NOTE: this calculator also assumes linear (or straightline) growth during both the accumulation phase and the distribution phase. We all know that we don’t live in a linear world. That said, it’s still a decent way to look at retirement planning.
So there you have two ways to help you determine how much you need at retirement. Yes, they both work off a lot of assumptions, but I’m afraid that’s the best I can do. There’s just too many variables to get it nailed down any harder than what we just looked at. One thing you can do is look at these numbers once a year to see how you are doing. If it looks like you are going to fall short or your needs change, you can make adjustments.
There’s more to this. Next time, I’ll talk about figuring out how much you need to save each month in order to reach your goal. Until then, please feel free to offer up any comments or suggestions about today’s post.