Post #7 – Retirement Planning Simplified, Part I

For those of you who would like a simple method to quickly estimate the amount of assets necessary to fund your retirement, and how much you need to save annually, the next couple blog posts are for you. The essence of retirement planning simplified. This post will provide a 4-step process that can be used to estimate a ball-park retirement nest egg figure to fund a 30-year retirement.  This method is for those people who, whatever their age, are just starting a serious retirement savings plan and at this point need a rough target figure. This 4-step process will only provide a rough figure because it requires a lot of assumptions about the future that may not yet be known. The retirement lifestyle you hope to live, the future inflation rate, and future market returns, etc. are variables that will affect your final nest egg size. As you get closer to your retirement date, you should work with a financial planner to help you apply more rigor to the process I have presented here. The 4 steps are:

Step 1: Estimate your Annual Living Expenses

Step 2: Estimate any Annuity Benefits

Step 3: Estimate your Net Annual Living Expenses (NALEs) to be sustained by your Nest Egg

Step 4: Estimate your Retirement Savings Goal

Once you complete these 4 steps you will have a rough estimate of the size of your retirement nest egg, in today’s dollars, necessary to reach your retirement goal.

Step 1: Estimate your Annual Living Expenses

When trying to determine the size of your retirement nest egg, the most important exercise is to estimate what your annual living expenses will be in retirement. When you are 30 years old, this may be difficult to do, because your life is likely to change significantly by the time you retire. If you are 50 years old, estimating your living expenses should be a lot easier but it is still a difficult task. There are many publications that suggest you should use 70% to 80% of your current annual income when estimating what you’ll need in retirement. This view does make some sense because it is based on the simple fact that when you retire, you will no longer be paying FICA taxes, about 7.5% of your gross income. Also your savings rate will decrease as you will finally be at the stage of life where you are spending your nest egg and not trying to grow it. It is also possible you may be in a lower tax bracket during retirement.

However, there are many variables in how your spending could change between now and retirement. For example, if you are younger, you may be paying off your school loans. If you are older, you may be paying for your children’s school expenses. Also if you are currently paying a mortgage, it may be paid off when you retire. In order to retire at our chosen time, my wife and I reduced our retirement living expenses to about 50% of our last year of earned income. In reducing our retirement expenses to this 50% level, we chose to make some sacrifices to our retirement lifestyle. For us, being able to live life on our own terms was more important than having more material possessions.

For the average person reading this blog with an income in the $40,000 to $60,000 range (or perhaps a family income of $70,000 to $100,000 per year), assuming a retirement income that is only 50% of their earned income will, in most cases, not be realistic. I think, given an average income, using 80% of current income to estimate your eventual retirement living expenses is as good as any other assumption. However having a good handle on your expected retirement living expenses is important, so the process of estimating your retirement living expenses should be re-examined often.

If you are in your 40s or older, I would get into a habit of tracking your annual living expenses. For the past 15 years, from the time I was about 40 years old, I have used a software package developed by Intuit, inc. called “Quicken” to track our family expenses. There are other similar financial software packages that work as well. Quicken software is really nothing more than a sophisticated electronic check book. When I started using Quicken, I never again used my paper check register. Instead I entered all my checks, bank drafts, deposits, and credit card transactions into the software. Once you are in the habit of entering all your financial transactions into a software package, then you can take advantage of some of its features, such as the flexibility to  generate  annual (or any time period) reports of your living expenses.  During the last 10 years of my working life I would have Quicken generate a 2-year report of my living expenses. I would remove all the large one-time costs (like buying a car or replacing a roof), and calculate my average annual living costs. I would generate this report about every six months or so, to monitor any changes in our spending habits. Using financial software was the approach we used to estimate our living expenses, but it is not the only method. Find one that you are comfortable with and is accurate. Having a realistic estimate of your future retirement living expenses is very important.

Step 2: Estimate any Social Security or Employer Pension Benefits

In Step 2 you need to determine the amount of annuity income (i.e., social security and employer pension) benefits you expect to receive. I discussed earlier in Post #6 the current thinking by the financial planning community on government and private pensions. If you have not already, you should contact the Social Security Administration for your social security benefit statement and your employer’s human resources department for your projected employer benefit (if applicable). Again I would recommend that you be very conservative in assessing how much of these benefits you will actually receive down the road; especially if you are still far away from your retirement date.

Step 3: Estimate your Net Annual Living Expenses (NALEs) to be Sustained by your Nest Egg

All your annuity income sources from Step 2 should be added together and subtracted from your total estimated annual living expenses estimated in Step 1. The result is your Net Annual Living Expenses (NALEs) that your personal retirement savings plan must support for the rest of your life. By some outside chance if your annuity income is greater than your estimated annual living expenses, you are one of the lucky few who do not have to save any other funds to support retirement. However I would recommend you review your estimated living expenses in Step 1 to be sure you have included all costs. People often forget things they do not pay for on a regular basis such as buying a new personal computer every 3 or 4 years. People also tend to underestimate things they are not used to paying for while working, such as health care costs.

Step 4: Estimate your Retirement Savings Goal

Once you have your estimated your NALEs from Step 3, it is only one simple calculation to determine your retirement savings goal.  You multiply your NALEs by 25. This amount is the total nest egg you will need to have accumulated (in today’s dollars) to support your NALEs for 30 years.

Why multiply by 25? Multiplying your net living expenses by 25 is the inverse calculation of multiplying your retirement nest egg by 4% to generate your net living expenses (i.e., $10,000 x 25 = $250,0000 is the inverse of 4% of $250,000 = $10,000). There have been several studies published in the last 20 years that concluded that if you limit your initial withdrawal amount from your nest egg to 4% (increased for inflation each year); your nest egg has over a 90% chance of lasting at least 30 years. Now these studies have made certain assumptions about portfolio construction, average market returns, etc. that need to be understood. But for this simple planning process, the 4% withdrawal rate is a reasonable assumption to make. In a future blog I will discuss the assumptions that support the 4% “Safe Withdrawal Rate” (SWR) and some variations to this rule that can allow you to withdraw more than 4%. In the meantime multiplying your NALEs by 25 will give you a reasonable estimate in today’s dollars of the size of your nest egg at retirement. You should monitor your progress toward this financial goal every year, making adjustments where necessary, until you reach the goal hopefully on or about your planned retirement date.

Before ending this post a word must be said about inflation. It is important to realize that the retirement savings goal calculated in Step 4 is in today’s dollars and will need to be increased each year for inflation to maintain purchasing power. This inflation increase will be accounted for in your annual savings. Your annual retirement savings will increase each year along with your income.  Estimating what your annual savings rate should be is the subject of my next post.

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