You need to work to sustain your lifestyle -- but you also hope your hard work provides you with a comfortable retirement. Reaching retirement age only to learn this dream won't come true can devastate anyone. Make sure that doesn't happen to you. You can retire successfully, but you'll need some careful planning. These 6 steps will help you get started.
1. Determine when you want to retire
Picking a retirement year lets you set a time horizon -- a key measure for retirement planning. The closer your retirement date, the less aggressively you need to invest. If you don't reduce your equity exposure as you near your retirement date, you risk entering a bear market in the years before retirement. On the flip side, not investing aggressively enough while you're younger means your accounts won't grow as well as they otherwise would. Both outcomes might leave you without enough money to survive during your retirement years.
For younger workers, choosing a retirement age may feel premature -- but it is vital. The date you pick is a target, and it's not set in stone. You'll just need flexibility throughout the years if your life changes unexpectedly, especially as your retirement date nears. If you experience a major life event like buying a new home or receiving a promotion, you need to update your plan to account for it.
2. Assess your income sources in retirement
Do you work for a company that will provide you with a pension? At what age will you take Social Security, and how much money will you receive each month? A few people have retirement income sources that meet or exceed their working income, but the majority will make far less.
Figure out how much less by auditing your retirement income sources. That will let you know how much of your income in retirement will come from your investment accounts. The more sources you have, the less your retirement savings will supplement your income in retirement.
3. Assess expenses in retirement
How much you spend during retirement also matters. The presence or absence of regular monthly payments like a mortgage or car loan will affect how much money you'll need each month. Fewer expenses mean you can get away fewer retirement assets.
If you don't have many income sources, you'll cover your expenses by withdrawing from your investment accounts. Studies have shown that with a 50% stock/50% bond portfolio, withdrawing 4% a year will sustain your funds over a 30-year period. You'll want to keep your expenses low enough that your withdrawals don't exceed that amount.
4. Adjust for inflation
Inflation means that you can buy things for less money now than they'll cost in the future. If you've ever heard your grandma or grandpa complain about how everything costs more now today than when they were young, that's inflation. One day, you'll be the grandparent; instead of complaining about future prices then, you can prepare for them now.
Start by adjusting the amount of money you'll need each year by the expected rate of inflation -- about 3% annually -- and remember to compound that figure for every year you intend to spend in retirement. That number may not seem like much year to year, but over 20 years of retirement, you can expect the price of goods and services to double.
5. Determine asset allocation
Asset allocation determines which asset classes you invest in, and how much you devote to each. It is the driving force behind how much your accounts will grow. Shouldering a higher level of risk will leave your portfolio more heavily weighted in stock. It'll grow more over the long term, but also face greater turbulence. If you've invested too conservatively, your funds may not grow enough, and you'll fall short of your retirement goal. If you're too aggressive, you get swamped by market volatility, sell out of your investments, and fail to meet your retirement goals.
Your asset allocation model will take into account your risk-taking ability, with special attention paid to your personal feelings about volatility and your past reactions to market declines. There are many ways to determine this mix, but one of the easiest ways is by taking a risk tolerance quiz.
6. Make up for gaps
After taking all of this into account, you'll come up with one of three scenarios:
- You're saving more than enough and can splurge some during retirement!
- Your money will last just long enough in retirement, given your life expectancy.
- You end up with a gap. The amount of income that you can generate each month is less than your expenses, and you won't have enough money to live off of during your entire retirement.
If you find yourself in the latter scenario, you can still make up for these gaps. Working part-time during retirement can supplement your other income sources. Winnowing down your expenses before you stop working can also improve this gap. You can also consider tweaking your asset allocation. Investing in a greater proportion of stocks will help your accounts grow over time; just make sure you can handle the extra risk.
No matter what, you absolutely must track your progress and make changes as necessary, especially if a major life event changes your plan Successfully saving enough money to last throughout your entire retirement is a huge accomplishment. Achieving that goal starts with having a plan. A successful retirement is within your reach, but it will take time, diligence, and action on your part to make that dream come true.