July 9, 2006

$tarrBuck Report July 9, 2006

by R. M. Starr

How Much Do You Need to Save for Your Retirement?

It happened to Paul McCartney! It could happen to you! Not stardom — facing retirement. How much should you be saving now to support yourself decades from now? For most Americans, the answer is “more than you’re saving now.” But of course that’s not a useful answer. We need a number. How much should we be putting aside monthly or annually?

This isn’t an easy math problem for a few reasons. There’s uncertainty on all sides: how long will you live? what will your investment returns be? when will you retire? how much will Social Security pay? what will inflation do? Even when we’ve used our best guesses to solve these issues there’s the arithmetic. It involves compound interest. That’s always a bit tricky. Then there are taxes — they can sap the growth of the most robust investment plan.

The starting point is four numbers: How much have you got now in funds that can be used for retirement (not vacation savings or the kids’ college funds)? How much income will you need from your own savings? How long until retirement? How long should your retirement funds last?

To deal with inflation, the way to figure is in ‘real’ inflation-adjusted dollars and investment yields. To figure out how much income you’ll need from your own savings, start with a target spending level, then subtract the other sources of retirement income: Social Security (yes, it will be there, just not so generous), defined benefit pension plans. The difference between your target spending level and your other sources of retirement income is what your wealth and saving need to provide.

An example. Joan Frank is a single professional woman age 45. She’d like to retire in twenty years at age 65. Joan comes from a long-lived family; her plans need to go to age 90, twenty-five years from retirement. She could be hit by truck tomorrow, or on her 66th birthday, but the retirement plan had better go to 90. Joan has been contributing regularly to 401(k) plans so she has $100,000 accumulated there, but there’s no defined benefit retirement plan so she’s on her own. Her Social Security statement says to expect $25,000 a year in Social Security benefits (until the trust fund runs dry). Joan has a mortgage on her condo but she figures it will be paid off by retirement and the condo will be worth (in today’s dollars) $400,000. But that’s not money you can readily tap into. Joan figures $60,000 a year is a reasonable retirement spending target, assuming the condo is paid off. After Social Security that leaves $35,000 a year she needs to come up with from her own resources.

How much can she expect from the money already in her 401(k)? We need to make a guess now. What is the average annual real (net of inflation) return she can expect? A moderately conservative figure (averaged over the twenty years to retirement) is 5% annually real. That reflects a mix of stocks and bonds and a margin of safety. Joan figures the compound return to $100,000 at 5% annual growth over 20 years. She expects the fund to grow to $265,000 (real) in twenty years. To see how Joan figured this total out go to http://www.moneychimp.com/calculator/compound_interest_calculator.htm. Then over the next 25 years it can provide annual withdrawals of $ 18,000, running the balance down to zero over Joan’s twenty-five year retirement. For this calculation go to http://www.moneychimp.com/calculator/annuity_calculator.htm.

Joan is halfway there. She wants $35,000 spending a year and she’s found $18,000. She needs to save in addition enough over the next twenty years to provide $17,000 a year additional spending. Once she’s retired she’ll be running down her savings, but that’s part of the plan. How much does she need to save each year to age 65? The arithmetic is a bit messy, but $7000 saving a year should do it. Joan puts $600 a month into an IRA or 401(k). Those tax-sheltered plans allow the money to grow without being slowed down by taxes. Joan figures that compound interest means that those contributions (totaling about $140,000) will grow to about $230,000 in twenty years, enough to sustain her spending plan of $17,000 a year.

Is there a risk here? Yes, all the uncertainties we started with are still there. Financial markets could disappoint; Joan could be exceptionally long-lived. But now Joan has a plan. There’s room for adjustment as time goes on. Joan should recalculate in five years. She may need to increase her annual saving. Or she may be able to reduce it. At age 55 she may need to plan to postpone retirement for a year or two. If she’s managed to save more than she initially planned, she may be able to accelerate retirement. She may want to use a more conservative investment portfolio after retirement — that will reduce average returns and mean she wants to reduce spending a bit.

The plan should work out. But there are fallbacks if needed after retirement. Reverse mortgaging the condo, buying an annuity later.

Planning, saving, taking advantage of tax shelter and the power of compound interest are the cornerstones of retirement saving. Having a target, making a plan and sticking to it let you look to the future with confidence.

(c) Copyright R. M. Starr 2006

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