How to Calculate Your Retirement Needs

by Patrick Totty

If you're like almost half of all adult Americans, you haven't made any real retirement plans or put aside savings for it.

Planning for retirement is crucial.

Planning has become mostly a do-it-yourself thing. That's because traditional sources of retirement income either are taking less responsibility for your retirement or are becoming less important. Many employers are abandoning traditional "defined-benefit" retirement plans where they assume the investment risk. Instead, they're turning to "defined-contribution" plans where you, the employee, must bear the investment risks. Social Security is less and less able to serve as an adequate source of primary retirement income.

Longer life spans complicate your plans for retirement. If you turned 65 today, you reasonably could expect to live into your early 80s--many people will live into their 90s. That means you must plan for 20 to 25 years of life after retirement. You have to build a portfolio that can resist inflation and market fluctuations, and sustain you comfortably over a long period of time.

Retirement is no longer a one-size-fits-all scenario where you leave a job at 65 and live for a short time afterward on a pension and Social Security. Today's "new retirement" includes options that range from retiring early (55 and younger) or working part time at your old job, to starting a new business, or "dipping" in and out of the job market at will in your later years.

How much will you need?

The old rule of thumb says you'll need at least 70% of your preretirement income to maintain your current standard of living. This assumes you'll be paying fewer taxes because you're no longer receiving earned income and that you have completed your major material acquisitions--house, furniture, car--expenditures that require a higher level of income and outgo. This also assumes you have paid off all credit card debt.

We say "old rule of thumb" because increased life spans are making that 70% figure suspect. When pension plans and Social Security were introduced, the retirement age of 65 was considered old. Most people who reached it and retired didn't have too much longer to live. With increasing life spans, that means you must plan for at least 15 years of retirement. You also should take long-term inflation and the consequences of aging into account. Inflation, even if low, compounds over the years, slowly eroding the buying power of your dollars. You'll also face higher medical bills as you age.

One factor is making the 70% benchmark obsolete. Because people are retiring in good health, they're more inclined to be active--to travel, entertain, and want to continue at their accustomed level of consumption. This means your best bet is to plan to retire at or as close to your preretirement income as possible.

Determining how much you'll need

Your calculation will go like this (we've factored in a Consumer Price Index inflation rate of 3.15% per year, which has been the average rate of inflation in the 20 years from 1983 to 2002). Assume

1 (your estimated annual income at the time you retire) x 1.0315 (inflation factor) = what you'll need to maintain your current lifestyle

This shows how much you'll need as you enter your first year of retirement. Multiply that result by the same formula to see how much you'll need in your second year. Repeat this 15 or 20 times to see what inflation will do to your dollars over the years. The total of all those calculations--year one + year two + year three, and so on--is how much money you'll need for retirement.

For example, if your income at retirement is $50,000 per year, you'll need $51,500 to produce the same buying power in your first year of retirement. In year five, you'll need $58,387; in year 10, you'll need $68,181; in year 15, you'll need $79,617; and in year 20 you'll need $92,973. Over a 15-year retirement, you'll need $970,000 in income. Over a 20-year retirement, you'll need $1.4 million.

If you plan to live at a more modest level after retirement, multiply the inflation factor by 0.9, or 0.8, or 0.7 of your current income.

To determine how much you must save, your calculation must take the following into account:

How much money can you expect from Social Security? To find out, visit Social Security online. Three calculators will appear with different options. How much money can you expect from pensions or trust funds? What's the difference between the total amount you'll need and the income you'll receive from Social Security, pensions, and trust funds? The answer to this question will be how much money you must save.

Your savings formula becomes:

Amount annually saved x number of years x interest rate = the money you'll have to retire on.

Use this compounding calculator to get a quick estimate of what numbers you should put into the equation above. The same calculator shows, for example, that a couple jointly saving $5,000 per year for 20 years in an IRA at 6% interest will have $195,000. At 30 years, they'll have $419,000. At 8% annual growth, the 20- and 30-year sums would be $247,000 and $612,000, respectively. (Again, you can see the advantage compounding bestows on people who start saving early.)

You'll need to remember that each section of your portfolio at retirement will have a different withdrawal rate. You'll want to consult with a professional adviser about how to best arrange the cash flow you seek.

Taking inflation into account

Inflation has dramatically slowed since the 1980s, and there even are signs that the U.S. economy over the next few years could slide into a deflationary phase. Millions of baby boomers will retire over the next 15 years and there may not be a large enough number of younger people behind them to buy up their houses and properties. An oversupply could drive prices down, denying retiring Boomers their hoped-for level of return.

On the other hand, Boomers stand to receive $16 trillion in transferred wealth from their parents' generation by 2020, most of it as property. It might seem that this immense wealth would be inflationary, but Boomers still will face the problem of small markets where they can cash in.

The chances of high inflation, even with government deficit spending or boomer inheritances flooding the economy, doesn't seem likely. That's why we think a 3.15% per year inflation factor should be sufficient for your calculations.

When are you ready to retire?

Objectively, you're ready to retire when you have enough set aside to allow you to receive at least 70% of your current income for 20 years without ever having to work again. You also should be debt-free, with your mortgage, car, and credit cards paid off. You should have enough potential income to handle rising medical, life, and long-term care insurance premiums as you age.

Subjectively, you're ready to retire when: Your current line of work no longer inspires you; You are physically less and less able to meet the demands of your job; or You find yourself wanting to take on a new vocation, step up your volunteer work, do long-term travel, or even start a new business

On the other hand, you may be a person who's never associated getting older with having to retire. Although the federal government has set ages at which you may draw full Social Security benefits (66 starting in 2004) and must begin withdrawing distributions from your IRAs (individual retirement accounts) and other tax-deferred savings plans, there are no rules that say you must retire at a certain age. (Do keep in mind that you must begin taking distributions from your IRAs and similar investment plans by age 70 �.)

November 17, 2003