Estimating your retirement nest egg

For most Americans, retirement planning is ultimately focused on accumulating a “nest egg” of savings and investments to generate enough income to pay for a comfortable lifestyle.

To find out how large a nest egg you will need you must first estimate your “retirement income gap”. This is the difference between how much you’ll need each year to enjoy the lifestyle that you want and the amount of income that you expect to receive from sources including Social Security, employer pensions and part-time work. This gap will need to be filled from your personal savings and investments.

For example, using today’s dollars, let’s say you plan to retire at age 66 and determine you need $75,000 per year (before taxes) to enjoy a comfortable retirement. If you only receive $25,000 in income from Social Security, your investment portfolio will have to generate $50,000 every year after inflation for as long as you live. Using Social Security as the only income source simplifies the calculation because the benefits are automatically adjusted each year for inflation.

So how large a portfolio is necessary to generate $50,000 annually in inflation-adjusted dollars for as long as you live? Since running out of money is the number one concern for most retirees, much attention has been focused on this subject. The research has been directed specifically toward determining a “sustainable portfolio withdrawal rate”. This is the maximum amount that can be withdrawn from your retirement assets each year with reasonable confidence that the portfolio will provide a lasting income. Once you arrive at a withdrawal rate you are comfortable with, you can estimate the size of the portfolio required.

In 1994, Bill Bengen (a California financial planner) conducted a seminal study. His research suggested that based upon historical (1926-1975) inflation rates and investment returns, a retiree’s portfolio consisting of approximately 60 percent stocks and 40 percent bonds should, with a reasonably high probability, last for approximately 30 years. This was possible if an investor initially withdrew no more than 4 percent of the portfolio balance, and continued withdrawing that same inflation-adjusted dollar amount each year. Using this 4 percent guideline, if you determined that your retirement income gap was $50,000, you would need a portfolio of approximately $1,250,000 ($50,000 divided by .04) at the beginning of your retirement to fill that gap.

A caveat is in order here. While the 4 percent guideline can provide future retirees a target to shoot for, it is dependent upon several variables that differ from person to person and are impossible to predict with any accuracy. The best you can do is to make reasonable and conservative assumptions regarding how long you plan to live in retirement, what investment returns you expect to earn from your portfolio during retirement and what you expect inflation to be.

For those who want a high degree of confidence that they will not run out of money, it makes sense to be conservative about your future assumptions. Therefore, if you expect retirement to last longer than 30 years, or project future investment returns to be lower than historical returns, or anticipate future inflation to be higher than historical inflation, you should reduce your portfolio withdrawal rate below 4 percent. This means you will need a larger portfolio at retirement. Remember, the higher the withdrawal rate, the greater the chance the portfolio will not last as long as you need it to.

Compound Consequences

Underestimating the impact of compound growth on a household’s finances can lead consumers to make poor economic decisions including borrowing too much and saving too little. There are three main engines that drive compound interest on an investment made or a loan taken out. They are the amount invested or borrowed, the time horizon of the investment or loan, and the interest rate earned or paid. The longer the time horizon and the higher the growth rate, the greater the financial impact.

Most major financial decisions such as saving for retirement or repaying a loan involve large dollar amounts, long time periods and relatively high growth rates. Therefore, compound growth can have an enormous effect on an individual’s financial security. Even modest amounts saved can turn into substantial retirement nest eggs and small amounts borrowed can spiral into large debts over time. Read more

The Cost of Retirement

Retirement is expensive. How much money you will need each year when you stop working depends on your individual circumstances and the kind of lifestyle you expect to live. Your estimate will be the starting point of your retirement plan and will drive many of the other planning decisions you make, including those regarding Social Security benefits, your retirement date, and how much you need to save in the interim. There are two ways to arrive at this important number.

The most popular method is called the Income Replacement Ratio. It is the percentage of your working, pre-tax income needed to maintain your standard of living in retirement. It is based on industry and academic studies of retirees and generally indicates that most seniors need between 70 percent to 90 percent of their pre-retirement income. The assumption being that income and FICA taxes, and retirement savings contributions that consume 10 percent to 30 percent of a person’s income, will be reduced or end in retirement. It also assumes that work-related expenses that decrease in retirement will be offset by expenses such as health care that will likely increase. For example, if you have an annual gross (pre-tax) income of $50,000 before retirement, using the 90 percent rule of thumb would indicate you will need $45,000 per year in retirement. Read more