How many people actually go through the
process of calculating how much they'll need for retirement? According
to the Employee Benefit Research Institute, only 37% of Americans
have tried to calculate this amount. Of those who tried, only
34% used a form or worksheet to calculate the number. About 5%
just guessed at the amount, 2% used a number they heard somewhere,
and 9% didn't know how they came up with the figure (Source: Retirement
Confidence Survey, 2003).
Don't make the same mistake with your retirement
planning. To make sure you enjoy your retirement without financial
worries, you should make sure you have enough money saved when
you retire. That calculation can be a daunting task. A variety
of factors affect your answer and inaccurate estimates for any
factor can leave you with way too little in savings. Some of the
more significant factors include:
What percentage of your
pre-retirement income will you need? You can find various
rules of thumb indicating you need anywhere from 60% to over 100%
of your pre-retirement income. On the surface, it seems like you
should need less than 100% of your income. After all, you won't
have any work-related expenses, such as clothing, lunch, or commuting
costs. But look carefully at your current expenses and how you
plan to spend your retirement before deciding how much you'll
need. If you pay off your mortgage, stay in good health, live
in a city with a low cost of living, and engage in inexpensive
hobbies, then you might get by with less than 100% of your income.
However, if you travel extensively, pay for health insurance,
and maintain significant debt levels, then even 100% of your income
may not be enough. You need to take a close look at your expenses
and planned retirement activities to come up with a reasonable
estimate.
When will you retire? When
you retire determines how long you have to save and how long investment
returns can compound. Most people would like to retire before
age 65, but that typically requires significant personal savings.
You want to be sure your retirement savings and other income sources,
such as Social Security and pension benefits, will support you
for what could be a very lengthy retirement. Even reducing your
retirement age by a couple of years can significantly affect the
ultimate amount you need.
How long will you live? Most
people look at average life expectancies when estimating this.
But an average life expectancy means you have a 50% chance of
living beyond that age and a 50% chance of dying before that age.
Since you can't be sure which will apply to you, it's typically
better to assume you'll live at least a few years past that age.
When deciding how many years to add, consider your health as well
as how long other family members have lived.
What long-term rate of
return do you expect to earn on investments? A few years ago, many
retirement plans were calculated using fairly high rates of return.
Those high returns don't look so assured now. At a minimum, make
sure your expectations are based on average returns over a very
long period. You might even want to be more conservative, assuming
a rate of return lower than long-term averages suggest. Even a
small difference in your estimated and actual rate of return can
make a big difference in your ultimate savings. For example, assume
you estimate a long-term rate of return of 9%. If you save $5,000
per year in a tax-deferred account for 25 years at 9%, you'll
have $461,620 before paying any income taxes that may be due.
However, if your actual return is 8%, you'll have $394,772, a
difference of $66,848. (This example is provided for illustrative
purposes only and is not intended to project the performance of
a specific investment vehicle.)
Have you considered inflation? Even
modest levels of inflation can significantly impact the purchasing
power of your money over long time periods. For instance, after
30 years of just 2% inflation, your portfolio's purchasing power
will decline by 45%. When estimating an inflation figure, don't
just look at the historically low inflation rates from the recent
past. Also consider long-term inflation rates, since your retirement
could last for decades. For instance, inflation, as measured by
the consumer price index, has averaged 2.3% over the past five
years. However, it averaged 5% over the past 30 years (Source:
Bureau of Labor Statistics, 2003).
What tax rate do you
expect to pay during retirement? Especially if you save
significant amounts in tax-deferred investments that will be taxable
when withdrawn, your tax rate can significantly affect the amount
you'll have available for spending. You may find your tax rate
is the same or higher after retirement.
Once you've estimated these factors, you
can calculate how much you'll need for retirement.
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