Anyone who plans to retire at some point should run through this abridged formula to get an estimate of where they stand with their retirement goals. Five major questions need to be answered when figuring out how much money you will need to save to retire and live a lifestyle similar to what you are accustomed to. Stick with me through this though. I'll offer a short-cut on the math in the middle.
- When will you retire? This answers how many years you have left to save.
- How long will you need your money to last? This depends on you answer to question number one and how long you live. Not many of us know the answer to when we'll stop needing money too far in advance, but you can make an estimate based on your health and the lifespan for your parents and grandparents.
- What will your return be? If you use historical averages, minus taxes and advisor fees and a realistic allocation for stocks, bonds and cash you can be somewhat accurate. I like to estimate lower than historical averages on this one. If you beat your goal then retirement can be achieved earlier than planned or you can expect to have more to spend during retirement.
- What will the rate of inflation be? This answer is ever changing, using historic averages (or slightly higher) is a reasonable and safe approach.
- How much will you spend while retired? This depends on how active you plan to be and if your major debt is paid off before retiring.
These five factors cover most of the planning needs, but does not include healthcare costs or any contribution from social security which we don't believe to be viable long term (at least in the current amounts). To work through some of the unknowns and get a ballpark idea of how you are doing on your road to retirement try this formula:
((Current Spending - Mortgage Principle and Interest - Children Expenses) x 12 x 2)/0.04 = Nest Egg Goal if you'd like to retire in 25 years.
- Start with how much you spend per month now.
- Deduct your principle and interest for your house payments (taxes and insurance have to stay in). This is assuming you own a home and will have it paid off by the time you retire.
- Then deduct an estimate of what you spend monthly on your kid(s) if you have any.
- Multiply this number by 12 (months) to see what you will need in annual after tax income, not counting inflation.
- For each 25 year period double this number to help account for inflation.
- Divide this number by 0.04. This gives you your target nest egg goal.
For example...
A 40 year old couple with two kids who want to retire by the age of 65 who spend $10,000 monthly on average will need $3,000,000 saved by the time they retire. This is the case after their house is paid off and they stops paying $2,000 in principle and interest monthly. Also, by the time they retire they won't have child raising expenses and can spend $3,000 less each month (2 kids for $1,500 each including college savings). Without the mortgage and children costs they only spend $5,000 per month or $60,000 per year after taxes. To adjust for inflation they have to double their current spending from $60,000 to $120,000. To make the money last for 25 years during retirement they should only plan to be able to pull out 4% after taxes to live on. $120,000 divided by 4% equals $3,000,000. If they maintain their same spending habits, this nest egg will last approximately 25 years, until they are 90 years old.
If you are not sure you will reach your goal by the time you'd like to retire it's time to start spending less and saving more. The only other option is to plan to work part time during retirement to subsidize your income. If you think you will reach your goal earlier than planned it could mean you can retire sooner, spend more during retirement and/or leave more as an inheritance.
This formula only produces a rough estimate of what you will need and does not factor in possible inheritance you will receive and other factors such as long term care. Talk to an AF Capital Management Representative for a full financial plan catered to you.
