Friday, May 28, 2010

Your Retirement Goal

Setting goals and targets is part of the investment process. Retirement is a goal for most people. How do you determine your target for your retirement savings? This isn’t something that can be fully answered in a short blog post, but it’s something that most people probably should think more about. Here are some guidelines that may help.

Assuming that you will retire someday, either by choice or necessity, you’ll obviously need a source of income other than employment income. For most people, Social Security will provide part of that income, but it’s unlikely to be enough for most people to live on – at least the way they’d like to.

In the past, pensions (defined benefit retirement programs) provided a good portion of retirement income for many people, but pensions have been phased out to a large extent. Currently most working people won’t receive pension income, and instead will need to rely on IRAs and defined contribution retirement programs like 401(k) and 403(b) plans. In other words, it’s up to you to save and invest enough to supplement your retirement income beyond what Social Security will provide. So, how do you figure out how much you’ll need to save?

There are several rules of thumb used by financial planners. While these provide rough guidelines, and are not sufficient to do thorough retirement planning, they will at least give you a ballpark idea of the savings you’ll need to accumulate, and what percentage of your employment income you’ll need to save to reach your retirement savings target.

One rule of thumb is that in retirement you will need about 70% of your current income (in today’s dollars; i.e., not factoring in inflation) to live your current lifestyle. One major cost you won’t have in retirement is saving for retirement; i.e., if you are saving 10-20% of your income for retirement, then you can subtract 10-20% from your current income. You also won’t have costs related to working, such as commuting or work clothes. You also may have paid off a home mortgage and have no child care costs. Of course some costs are likely to increase, such as medical costs. For our example, we’ll use the 70% figure, and assume a current gross (before tax) annual income of $60,000. This gives us 0.7 * $60,000 = $42,000 as our required retirement income (in today’s dollars).

After estimating your required (or desired) retirement income, subtract your estimated annual Social Security benefits. You can estimate this with one of the Social Security benefit calculators on the Social Security website,; also, you should receive an annual statement from the Social Security Administration with an estimate of your Social Security benefits. Since Social Security benefits are indexed for inflation, you can use benefits in today’s dollars at this point in your calculations. For our example, we’ll use an estimate of $20,000 in annual Social Security benefits (in today’s dollars).

If you are lucky enough to have some sort of pension or other retirement benefit, subtract that from your required retirement income, but be sure to account for inflation. If your pension or other retirement benefit is not indexed for inflation, then you must factor in the decreased purchasing power over the years due to inflation.

For our example, we’ll assume no pension, so we subtract the $20,000 in Social Security benefits from the $42,000 required retirement income leaving us with an annual retirement income shortfall of $22,000 (in today’s dollars). This is the amount that must be funded by our retirement savings. So, how much do we need to save to generate $22,000 annually in today’s dollars, with a high probability of lasting the 30 years or more that we may live after retiring?

A common rule of thumb is that you should not withdraw more than 4% annually from your retirement savings. This rule of thumb assumes a 50/50 mix of stocks and bonds held throughout a retirement lasting 30 years, and is based on the historical performance of US stocks and bonds since 1926. Some advisors consider this too aggressive, and recommend limiting withdrawals to 3% or even less. Other finance professionals advise against owning any stocks for retirement savings, and investing only in inflation protected securities, such as TIPS; the calculations for the TIPS approach are somewhat different than those used here.

Using the 4% rule of thumb, we divide our $22,000 annual retirement income shortfall by 0.04 (or multiply by 25) which gives us a required savings amount of $550,000. However, since this is in today’s dollars, we now must adjust for expected inflation. For our example, we’ll assume an average 3% annual inflation rate, a current age of 25 and retirement age of 65, giving us 40 years until retirement. To adjust for a 3% inflation rate, compounded annually for 40 years, we multiply our required savings by (1.03)^40 = 3.26, giving us 3.26 * $550,000 = $1,794,120. Incidentally, if we run the calculations using the more conservative withdrawal rate of 3%, the future value (inflation adjusted) of the required savings is $2,392,161. For our example, we’ll use a retirement savings target of $2,000,000.

Now we need to think about how much we need to save to achieve our retirement savings target. This requires estimating a rate of return on our savings or investments. For our example, we’ll assume a 6% annual rate of return (before inflation) compounded over 40 years (e.g., from age 25 to 65). Using these numbers (and our inflation adjusted savings target of $2,000,000), our required savings rate (calculated using a spreadsheet formula or financial calculator) is about $12,000 per year. Note that this is 20% of our gross income of $60,000. That may seem like a lot, but it’s the bleak truth that comes out of our calculations.

There are lots of refinements that can be made to come up with a better estimate of how much you should save for retirement, but this simplified approach should highlight the most important message for retirement savings: you must start early and save a significant percentage of your employment income to have a reasonable probability of having enough retirement income to live comfortably for up to 30 years in retirement. The later you start, the more you must save as a percentage of your income, and/or the longer you’ll have to work before retiring. Hopefully this will motivate you to get serious about saving and investing for retirement, and maybe do some more research on the web or by reading a good book or two on retirement planning.

As always, I’d be glad to hear your questions and concerns about this topic, and see what we can do to help you work through your own personal example.

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