Knowing how much money you will need to have after you stop working, either coming in as a stream of income or from your retirement savings is one of the most important financial questions of your life. Of course, estimating the amount of cash that you will realistically require in order to successfully navigate the final phase of your life can seem like a daunting and complex issue requiring hours of complex calculations and a great deal of research. But breaking down this equation is not quite as difficult as you may think; you just need to learn how to start translating dreams and ideas into dollars using some basic time-value-of-money calculations.
What would it Cost to Retire Today?
The first step in answering the question, “how much will I need to retire” is to find out what it would cost to live that dream today. If you’d like to travel the world when you retire, take an afternoon and do some research to find out what you would pay to do that now. Be sure to include the current cost of all other normal living expenses, such as the price of healthcare and insurance for a retiree with your level of health and rent or a mortgage payment for the kind of residence that you would like to live in when you retire (unless, of course, you intend to continue living in your current residence at that time.) Also remember to factor in retirement of debts, such as your current mortgage or car payment if they will expire during your retirement. Be as detailed as possible so that you can create a realistic hypothetical cash flow statement that represents the current expenses that you would pay if you were retired today.
What will it Cost to Retire Tomorrow?
Once you have some actual numbers to work with, it’s time to factor inflation into the equation. If you are going to retire in 15 years, then take the annual expenses that you computed in step 1 and multiply them by an annual rate of inflation, which has historically grown at about 3 percent per year. Therefore, if you will need $50,000 per year to live the lifestyle you want in retirement, then multiply that amount by 1.03 15 times (or use a financial calculator if possible) to find out the future cost of your lifestyle. In this example, the cost in 15 years would equal to about $77,900. Then get an estimate of your Social Security benefits and also any future guaranteed private pension benefits and then subtract them from your projected budget. Finally, multiply this number by the number of years that you estimate that you will live during retirement and this should give you a rough estimate of how much you will spend after you stop working. For example, if you will get $35,000 per year in Social Security income and another $10,000 per year from a defined benefit plan, then your unfunded expenses would come to $32,900 per year. Therefore, if you think that you will live for another 25 years after you retire, then you would spend a total of $822,500 that won’t be covered by your future guaranteed income during your nonworking years.
So How Do I Pay for This?
The final step in estimating how much you will need to retire is to determine the amount of money that you must have saved in order to cover the balance of your expenses during retirement. This amount will depend upon several factors, such as the rate of return that you earn on your nest egg both before and during retirement. If you have $500,000 saved when you retire, then in the example above, you would need to earn about 6.5% per year on your money in order to draw the additional $32,900 you will need annually to live out your retirement dream. If you wanted to fund your retirement in this manner, then you would obviously have to have a half million dollars saved by the time you stop working in 15 years. Computing the amount that you will have to accumulate each year until then would involve several variables, such as the amount that you have saved already plus the rate of growth of your portfolio.
The Bottom Line
The hypothetical cash flows used in this article are merely intended to show the general process for translating the cost of a future lifestyle into today’s dollars. There are obviously many factors that must be taken into account in these equations that were not covered here, such as income taxes and the possible need for long-term care. In most cases, it would be wise to seek professional assistance with making these computations from someone with a sophisticated retirement planning program that can account for all possible variables. For more information on retirement planning, consult your HR representative or financial advisor. Check out CNN’s simple retirement calculator or a more sophisticated calculator offered by the Index Funds Advisors.