Retirement Step 2: What Will It Cost?
"Bartender, a refreshing beverage and a dry cocktail napkin for a few calculations, please."
Pundits say you will need 60% to 85% of your gross household income today to sustain the same lifestyle after you retire. In theory, the higher your income today, the closer you are to the lower end of that scale. Fair enough, but Fools should look at this issue in a slightly different fashion.
Sure, we could sit down to a long, drawn-out process, in which we look at our expenses and try to anticipate what they would be in retirement. That's actually not a bad idea. But you can get a rough idea right now. You live comfortably today (we hope), and it's unlikely you'll be saving money or paying FICA (unless you choose to work) after you retire. Therefore, excluding those items from your gross income, you can come up with a number that's fairly close to what it would take to sustain your current lifestyle.
Simply put: Fools want a retirement income that equals our gross income today, less all savings and all FICA taxes.
How much is enough?
But you still have to decide what income you will need in retirement to live the way you want. Some folks can get by on much less than they use now, while others may decide they want more. It's a personal choice for all of us. So pick a number, Fool.
Now, let's talk about inflation. How much will inflation erode our savings between now and retirement, and how much more must we save to counteract that decline? What should that inflation rate be, anyway? (Use one of our calculators to see how much your savings will be worth years from now.) For how many years will we draw that income? Should it keep pace with inflation throughout those years? Will we draw down our starting retirement portfolio to support our income needs, or just live off the earnings while never touching the principal? If we can answer those questions, we can determine the starting portfolio we'll need at retirement to support us for the rest of our lives.
I think I need more napkins
We're getting into the realm of some fairly sophisticated calculations, based on several assumptions for which small variations could yield drastically different results. So we need a quick and dirty way to get an idea of what we need to get started. We'll save the more esoteric efforts for later.
Forget about inflation for the moment. Ignore Social Security and any company pension you may get. Pretend your money gets no return now or after retirement. But do count whatever you have saved for retirement as of today. Let's say that amounts to $20,000. Furthermore, let's say you want an annual income of $30,000 in today's dollars after you retire, that you will retire in 25 years, that you will live 20 years after you retire, and that you expect to meet your maker waving your last dollar bill.
How much do you need to amass by the start of your retirement to support yourself in your golden years, and how much do you have to save each year between now and then to get there?
Let's see. You need $30,000 a year for 20 years, so that comes to $600,000 needed for the first year of retirement. You already have $20,000 of that, so that means you're only $580,000 short. Divide the shortage by the 25 years you have to save it up, and you discover you only have to cough up $23,200 annually between now and the time you retire to a life of leisure.
Don't choke on your martini just yet...
Too much is omitted from this simple approach to provide a meaningful answer to the question at hand. Worse, the answer we do get makes the whole idea of saving for retirement seem impossible. But this is far from true.
To do things right, we must take a cold, hard, objective look at our desired income, subject it to a rational choice of assumptions, and make some detailed calculations. One of our Foolish Retirement calculators can help with the heavy arithmetic. (Check out the "Am I saving enough? What can I change?" calculator in particular.) But before you use any such tool, you need some preliminary information. At a minimum, you want to:
- Decide on the annual income you desire in today's dollars.
- Pick a retirement date.
- Determine your lifetime average inflation rate.
- Determine the average rate of return you expect on your investments before and after retirement.
- Determine the current market value of all your investments, including regular accounts, IRAs, and company tax-deferred savings plans like 401(k) plans.
- Obtain an estimate of any company-provided pension benefit.
- Obtain an estimate of future Social Security benefits (see Step 6).
Armed with this data, you can determine the annual savings required for you to enjoy the good life. You will also be able to play "what if" games and see the results quickly, should you decide to vary things like inflation, rates of return, date of retirement, and desired income.
We'll leave you with one last thought. The earlier you start, the easier it will be for you to amass the dollars you'll need on the day you retire. If you put $1,000 per year for 25 years into an investment earning 10% annually, you'll end up with $108,182. Wait just five years before starting that process, and on the same date in the future, you'd end up with only $63,002. That $5,000 you "saved" by waiting just cost you $45,180 in tropical drinks.
If you need more help figuring out how much you need to save for retirement, and how much you can spend once you're in retirement, take a 30-day free trial of Rule Your Retirement, the Foolish service featuring regular, in-depth discussions about how to crunch your numbers.
Now on to Step 3, where we'll show you where to get some free retirement money.