Step 1: Start with a concrete retirement income goal
For example, if you currently make $100,000 a year but save $10,000 into the company’s 401(k) and spend $20,000 of your income on a mortgage, you’re essentially spending $70,000 on your living expenses (after you exclude your mortgage). This might mean, assuming you pay off your mortgage before retirement, that you want $70,000 of annual retirement income. (If you know you can live on less when you’re retired, you might also adjust for that change.)
Step 2: Tally any retirement or pension benefits you’ll get, and then calculate the shortfall
Here’s the next step: Pay attention to the next benefits statement that you get from the Social Security Administration. If you work, you’ll probably get annual Social Security benefits that run from $10,000 to $20,000 a year. If you’re married and your spouse works, your spouse will receive similar benefits. So, a two-job family might easily get $25,000 to $30,000 a year in benefits. Perhaps even more in some cases. And be sure, also, to count any other pension benefits you’ll receive, such as military retirement.
After you know the retirement or pension benefits that you’ll automatically receive, calculate your shortfall in retirement income. For example, if you want $70,000 a year in retirement income and will receive $30,000 a year in Social Security, your shortfall equals $40,000. That’s the amount you need to get from your retirement savings. And that’s the amount that determines the savings you need.
By the way, while you hear frequently about the coming disaster in Social Security, the problem isn’t as severe as most people think. If the Congress does nothing—nothing—the system could continue to function throughout you and your children’s lifetimes simply by reducing benefits by 30% in about 2035. (Check your next statement for the ugly details.) Obviously, that cut is not good for any of us who are still around in 2036. Especially if Social Security represents our only retirement income. But a 30% cut in benefits isn’t quite the financial meltdown that some people talk about—especially with 30 years to prepare. However, it’s probably a good idea to reduce your expected Social Security benefit estimate by 30%. That adjustment lets you concretely recognize the true condition of the Social Security program.
Step 3: Calculate the needed retirement savings
After you know what sort of retirement income you’ll need, you can estimate the retirement savings nest egg that you’ll need in order to produce that income. The calculations are impossible to perform by hand, but any spreadsheet (such as Microsoft Excel) or any personal finance program (such as Quicken for Microsoft Money) will make the calculations for you. If you’re a business or individual client of mine, I will also happily make the calculations for you the next time I prepare your tax return.
In the meantime, here’s a rule of rule of thumb you can use—I call it the $20 rule. As a rough approximation, you need about $20 of retirement savings to produce $1 of income. For example, if you want $50,000 of retirement income from your investments, you need about $20 × $50,000, or $1,000,000 in savings.
Step 4: Budget your annual retirement plan contributions
If you work through steps 1 through 3, you realize that you need a large retirement savings account at the point you retire. That obviously leads to the questions, “how much do I need to save annually?” and “for how long?”
As a practical matter, you need to think about retirement savings as a 20, 25, or 30 year process. To calculate how much money you need to save to build a retirement nest egg of, for example, $1,000,000 in a specified number of years, you need a computer or financial calculator. But here are some example calculations. Note that if you want to save half the nest egg amount shown, you need to make half the annual contribution shown below. If you want to save double nest egg shown, you need to make twice the annual contribution shown below. Note that I assumed a 5% rate of return to adjust for the effects of inflation.
|Years of saving||Monthly contribution|
Step 5: Be smart about the way you invest
A couple of general comments about investing your retirement money: First, you should save for retirement using things like your employer’s 401(k) plan, SIMPLE-IRA, or (for self-employed people) pension plans like SEP-IRAs. When you do this, much and sometimes most of your savings comes from the federal government or your employer.
Second, you don’t need to be a genius to invest for your retirement. You simply need to avoid the mistake of thinking you can trade individual stocks (usually a disaster) and the mistake of thinking that a commissioned sales person who calls him or herself a “financial planner” knows investment secrets that will let you consistently beat the market indexes.
You should instead use stock index funds such as the Vanguard Total Stock Market Portfolio if you’re young or perhaps the Vanguard Balanced Index if you’re middle-aged or older. These tools let you invest at very low cost and with above average results. (One way to think about indexing is that you’re always paying the wholesale price for your investments rather than the retail price. Overtime, paying wholesale amounts to a huge advantage.)
May I make one related suggestion? Learn more about investing by reading one of the reputable investing books. I recommend anything Andrew Tobias has written, Vanguard founder John Bogle’s books on mutual funds and indexing, and Princeton University Professor Burton Malkiel’s A Random Walk Guide to Indexing. If you’re going to read only one book on investing, read Professor Malkiel’s book—it’s an easy 200pp.
Step 6: Have a backup plan
Because many people won’t be able to retire using anything that looks like a standard personal financial retirement plan, think about a working retirement. I’m not suggesting that you work at a job or business you don’t like until the day you die. But if you can position yourself to enjoyably operate a smaller business or work at a part-time job, that part-time job or business can very possibly take the place of hundreds of thousands of dollars of retirement savings. A $10,000 a year business or job, for example, may be worth as much as $250,000 in retirement savings.
If you’re interested in learning more about smart retirement planning, feel free to contact us.