You know how important it is to plan for your retirement, but how do you get started? One of the first steps should be to come up with an estimate of how much income you’ll need in order to fund your retirement. Easy to say, not so easy to do! Retirement planning is not an exact science. Your specific needs will depend on your goals, lifestyle, age, and many other factors. However, by doing a little homework, you’ll be well on your way to planning for a comfortable retirement.
Start With Your Current Income
A rule of thumb suggests that you’ll need about 70 percent of your current annual income in retirement. This can be a good starting point, but will that figure work for you? It really all depends on how close you are to retiring, as well as what you’re planning to do while retired. If you’re young and retirement is light years away, that figure probably won’t be a reliable estimate of your income needs (and let’s face it, over a long period of time it’s not much more than a wild guess!). That’s because many things will change dramatically between now and the time you retire. As you near retirement, the gap between your present needs and your future needs will likely narrow. But remember, you’re only going to use your current income only as a general guideline, even if retirement is well within sight. In order to accurately estimate your retirement income requirement, you’ll have to do some more cipherin’.
Project Your Retirement Expenses
As with any budgeting exercise, annual income during retirement should be enough (or more than enough) to meet your retirement expenses. That’s why estimating expenses is a big piece of the retirement planning puzzle. It’s bound to be difficult identifying all of your expenses and projecting how much you’ll be spending in each area, especially if retirement is still a ways off. To help you get started, here are some common retirement expenses:
- Food and clothing
- Housing: Rent or mortgage payments, property taxes, homeowners insurance, property upkeep and repairs. These may change dramatically – often the mortgage is paid off, or you may be looking to move and/or downsize. These changes can increase or decrease the figures needed to cover housing.
- Utilities: Gas, electric, water, telephone, cable TV
- Transportation: Car payments, auto insurance, gas, maintenance and repairs. Often in retirement auto expenses decrease dramatically since you’re not driving to the job daily. However, you may be travelling more (to see the grandkids, for example!), so plan accordingly.
- Insurance: Medical, dental, life, disability, long-term care. Again, these expenses may change dramatically, with the addition of Medicare to the mix, plus the inevitable “new” ailments you may acquire in your later years.
- Health-care costs not covered by insurance: Deductibles, co-payments, prescription drugs
- Taxes: Federal and state income tax, capital gains tax. Keep in mind that many states don’t tax retirement income – this could help you make decisions on relocating in retirement as well.
- Debts: Personal loans, business loans, credit card payments
- Education: Children’s or grandchildren’s college expenses
- Gifts: Charitable and personal
- Recreation: Travel, dining out, hobbies, leisure activities. These expenses tend to increase a bit when you have more time on your hands in retirement, but then after a few years begin to level off. Planning for higher outflows earlier in your retirement than later is a wise plan.
- Care for yourself, your parents, or others: Costs for a nursing home, home health aide, or other type of assisted living. This expense can be all over the board, depending on your own family, experience, and location. This also works just the opposite of recreation expenses (above) – less early on, more expense later in life.
- Miscellaneous: Personal grooming, pets, club memberships
Don’t forget that the cost of living will go up over time. The average annual rate of inflation over the past 20 years has been approximately 3 percent. And keep in mind that your retirement expenses may change from year to year. For example, you may pay off your home mortgage or your children’s education early in retirement. Other expenses, such as health care and insurance, are bound to increase as you age. To protect against these variables, build a comfortable cushion into your estimates (it’s always best to be conservative). Finally, have a financial professional review your estimates to make sure they’re as accurate and realistic as possible. Don’t forget to factor in insurance benefits (especially medical) as your out-of-pocket costs are likely to be much different in retirement than when you’re working.
Decide When You’ll Retire
To determine your total retirement needs, you can’t just estimate how much annual income you need. You also need to figure out how long you’ll be retired. Why? The longer your retirement, the more years of replacement income you’ll need to fund it. The length of your retirement will depend partly on when you plan to retire. This important decision typically revolves around your personal goals and financial situation. For example, you may see yourself retiring at 50 to get the most out of your retirement. Maybe a booming stock market or a generous early retirement package will make that possible. Although it’s great to have the flexibility to choose when you’ll retire, it’s important to remember that retiring at 50 will end up costing you a lot more than retiring at 65 because there will be many more years’ worth of expenses you’ll need to cover. Plus in your earlier years you’ll likely be more active (spending more money) than you will later in life when you may become more sedentary.
Estimate Your Life Expectancy
The age at which you retire isn’t the only factor that determines how long you’ll be retired. The other important factor is your lifespan. We all hope to live to an old age, but a longer life means that you’ll have even more years of retirement to fund. You may even run the risk of outliving your savings and other income sources. To guard against that risk, you’ll need to estimate your life expectancy. You can use government statistics, life insurance tables, or a life expectancy calculator to get a reasonable estimate of how long you’ll live. Experts base these estimates on your age, gender, race, health, lifestyle, occupation, and family history. But remember, these are just estimates. There’s no way to predict how long you’ll actually live. With life expectancies on the rise, it’s probably best to assume you’ll live longer than you expect. To be conservative, you might project out to age 100 (or longer, if longevity is in your genes!).
Don’t Forget to Inflate!
But you can’t just come up with an expense figure and simply multiply it by the number of years you’re planning on living… remember that little factor mentioned earlier: inflation? Not considering the impact of inflation can cause your plan to run off the rails – and soon you’d run out of money altogether. As we sometimes morbidly joke in this business, you may want to increase your bacon intake to match up with your portfolio’s longevity!
It’s a fairly simple matter to project out the future value of your retirement income requirement, using the average inflation rate of 3% (or higher to be more conservative), to give you a pretty good picture of the amount of money you’ll need when you retire. There are many calculators available on the internet to help you with this process – just go to your favorite search site (Yahoo!, Google, etc.) and search for “retirement calculator”. As an alternative, a financial advisor will be happy to work with you to come up with a reasonable figure for your own circumstances.
Identify Your Sources of Income
Once you have an idea of your retirement income requirement, your next step is to determine just how prepared you are to meet those needs. In other words, what sources of income will be available to you in retirement? Your employer may offer a traditional pension that will pay you monthly benefits (although this is becoming increasingly rare, especially in the private sector). In addition, you can likely count on Social Security to provide a portion of your retirement income, although many younger folks are making their plans without factoring in Social Security, just in case it’s not there in the long run. You can get an estimate of your Social Security benefits by visiting the Social Security Administration website (www.ssa.gov) to download a copy of your statement.
Other sources of retirement income may include a 401(k) or other retirement plan, IRAs, annuities, and additional investments. The amount of income you receive from those sources is dependent upon the amount you invest, the rate of return on your investments, the internal costs of the investments, and other factors. Finally, if you plan to work during retirement, your job earnings will be another source of income.
Make Up Any Shortfall
If you’ve been diligent about saving, or are fortunate enough to have a funded traditional pension plan, your expected income sources may well be more than enough to fund even a lengthy retirement. But what if it looks like you’re going to come up short? Don’t run screaming down a hallway (it doesn’t help) – there are always steps that you can take to bridge the gap. A financial professional can help you figure out the best ways to do that, but here are a few suggestions:
- Try to cut current expenses (in your working years) so you’ll have more money to save for retirement. This will have the added benefit of teaching you to get by on a little less both now and in the future, as well. Think of it as a “practice” retirement.
- Shift your asset allocation to increase the potential returns on your portfolio (always keeping in mind that a portfolio that offers higher potential returns most likely involves greater risk of loss).
- Lower your expectations for retirement so you won’t need as much money (no beach house on the Riviera, instead maybe you’ll plan to buy a Buick Riviera to drive to the rental beach house once a year!)
- Work part-time during retirement for extra income. Many folks are doing this nowadays, as the “kick back and relax” style of retirement is not their cup of tea. Staying active tends to maintain your health as you age, both physically and mentally.
- Consider delaying your retirement for a few years. Instead of a big fat “I QUIT” at your planned age, consider shifting gears and pursuing a different career, something that you’re passionate about that you always dreamed of doing.
I hope the above discussion helps you to be better prepared as you plan toward your retirement. Too often, I talk to folks about their goals for retirement, and they’ve never considered the income side – the primary aim they have in mind is a particular age. By focusing on the retirement income requirement, you can be much better prepared for a long, happy, restful vacation from “work”.