The One Formula You Need to Know for Retirement
Teresa Ghilarducci, the author of How to Retire with Enough Money, talks about crunching the need-to-know numbers—and exactly how to put away enough money for the big day.
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Maybe you've wondered: Is it really possible for me to come up with a dollars-and-cents figure? The answer, tentatively, is yes. I can't give specific financial advice. However, I can provide you with the guidelines you'll need to sit down with a pencil, papers, and calculator and come up with a rough estimate of the income you'll need in retirement and how much you're on track to have. The disparity between the two will tell you how much saving you need to do.
How much income will I need?
The short answer: enough to preserve your pre-retirement standard of living. That's what economists mean when we talk about a secure retirement. Generally, people want to go on living mostly the same way they did during their working years (except without that tedious going-to-work part). They want to buy the same kinds of groceries, pursue the same hobbies, and shop for clothes at the same stores. There might be outliers: a person with a modest income who dreams about retiring to an ocean-view house with a sailboat, or a couple with a big house and an expensive lifestyle who plan to downsize and live simply in a two-bedroom house, working in the garden. But we’re talking about the average person who wants to lead a life that fits into approximately the same budget.
But how do you put "pre-retirement standard of living" in dollar terms?
If you're like most people, in retirement you'll need 70 to 80 percent of your pre-tax, pre-retirement income. If you earn $100,000 per year, you'll need $70,000 per year, at minimum, to maintain your standard of living.
An important note here: The 70 percent target assumes you'll have paid off your mortgage by the time you retire. Start making plans now to make that happen, because the numbers on this point are trending downward. In 2014, only 65 percent of older people were mortgage-free, whereas in the 1980s, more than 80 percent of seniors owned their home outright.
The biggest factor in whether you can live comfortably on 70 percent of your previous income is where you stood on the income ladder most of your life. Wealthy people who are willing to cut non-necessary expenses can get by fairly easily on 70 percent. The working poor, however, can’t. They’ll likely need more than 100 percent, because they have no indulgences to trim from their budget, and medical expenses increase substantially after retirement, even with insurance.
It's likely that you fall somewhere between those two extremes. That's why economists suggest that for many middle-class individuals closer to 80 percent of pre-retirement income is approximately what's needed. That is an argument for downsizing your lifestyle now. Why? Because you're almost certainly not going to have 100 percent of your income in retirement. In fact, if your employer doesn’t offer a pension, and you're one of the one-third of middle-class Americans who has no money in a retirement account, you're likely on track to have about 40 to 50 percent of the annual income you had in your working life.
Even married couples in the top 10 percent—I'm still worried about them. Yes, they have incomes above $140,000 per year and an average total of about $450,000 in their houses, retirement accounts, and so on. But assuming half the wealth is in their house, leaving them with $220,000 to draw down over the rest of their lives, that'll give them about $10,000 per year—which, even with Social Security, is a long way away from $140,000.
Honestly, I'm not trying to scare you into hopelessness here. It's the opposite: I hope to motivate you to fiercely pursue a solid solution to your old-age income challenge. First, we’ll start with a realistic picture of the future, so you can bring your savings and your current lifestyle into line with it.
How much income will I have?
Knowing that retirement income generally has three sources—Social Security, a pension (maybe), and savings (perhaps supplemented with a post-retirement job)—it’s possible to estimate how much you’ll get upon retirement from these sources—but it’s not necessarily easy:
Social Security: At ssa.gov, you can check your earnings history and the estimated amount of your future monthly check. Remember, though, that amount assumes that your earnings history will continue on the same trend. If you take time off from work or are laid off, your Social Security benefit will adjust downward. If you get a promotion with a sizable raise, it’ll go up. Its size will vary significantly, depending on several factors. These include how old you are when you start collecting, how long you worked. In general, if you were a high earner and retired at age 70 in 2014, your Social Security benefit would be a bit more than $3,400 per month.
Your pension: In the average pension plan, a retiree will replace 2 percent of his or her income for every year worked (a 15-year employee would replace 30 percent, etc. ) Your estimate, then, will depend on how long you expect to have worked for your employer when you retire. However, policies vary: You may want to ask your HR representative to help you make this approximation.
Savings: It’s technically possible for you to use a compounding calculator to estimate how much money you’ll have accumulated in 20 or 25 years' time. But it's unwise. A compounding calculator will ask you for at least five things: the initial contribution (what you have in savings right now); your annual contribution, meaning what you earn; what you expect your raises will be; what percentage of your earnings you will contribute each year (if you use a compounding calculator, try to be realistic); and an assumed rate of return.
The rate of return is the part that can be a problem. Why? Most compounding calculators set a rate of return that’s too high, because investment fees aren’t taken into account. When you use a calculator, force down the assumed rate of return to 3 percent without inflation and 5 percent with inflation. I go a little lower, because, well, I’m an economist and I’m conservative on this issue. (A side note here: I like the AARP retirement calculator, because it calculates your Social Security benefit and you can change the assumptions easily.) Hey, what's the worst that can happen? If your returns outperform these cautious assumptions, you'll have enough money to improve your lifestyle in retirement, or you'll be covered if you live a little longer!
This is an excerpt from How to Retire with Enough Money and How to Know What Enough Is by Teresa Ghilarducci, published by Workman Publishing.
How much income will I need?
The short answer: enough to preserve your pre-retirement standard of living. That's what economists mean when we talk about a secure retirement. Generally, people want to go on living mostly the same way they did during their working years (except without that tedious going-to-work part). They want to buy the same kinds of groceries, pursue the same hobbies, and shop for clothes at the same stores. There might be outliers: a person with a modest income who dreams about retiring to an ocean-view house with a sailboat, or a couple with a big house and an expensive lifestyle who plan to downsize and live simply in a two-bedroom house, working in the garden. But we’re talking about the average person who wants to lead a life that fits into approximately the same budget.
But how do you put "pre-retirement standard of living" in dollar terms?
If you're like most people, in retirement you'll need 70 to 80 percent of your pre-tax, pre-retirement income. If you earn $100,000 per year, you'll need $70,000 per year, at minimum, to maintain your standard of living.
An important note here: The 70 percent target assumes you'll have paid off your mortgage by the time you retire. Start making plans now to make that happen, because the numbers on this point are trending downward. In 2014, only 65 percent of older people were mortgage-free, whereas in the 1980s, more than 80 percent of seniors owned their home outright.
The biggest factor in whether you can live comfortably on 70 percent of your previous income is where you stood on the income ladder most of your life. Wealthy people who are willing to cut non-necessary expenses can get by fairly easily on 70 percent. The working poor, however, can’t. They’ll likely need more than 100 percent, because they have no indulgences to trim from their budget, and medical expenses increase substantially after retirement, even with insurance.
It's likely that you fall somewhere between those two extremes. That's why economists suggest that for many middle-class individuals closer to 80 percent of pre-retirement income is approximately what's needed. That is an argument for downsizing your lifestyle now. Why? Because you're almost certainly not going to have 100 percent of your income in retirement. In fact, if your employer doesn’t offer a pension, and you're one of the one-third of middle-class Americans who has no money in a retirement account, you're likely on track to have about 40 to 50 percent of the annual income you had in your working life.
Even married couples in the top 10 percent—I'm still worried about them. Yes, they have incomes above $140,000 per year and an average total of about $450,000 in their houses, retirement accounts, and so on. But assuming half the wealth is in their house, leaving them with $220,000 to draw down over the rest of their lives, that'll give them about $10,000 per year—which, even with Social Security, is a long way away from $140,000.
Honestly, I'm not trying to scare you into hopelessness here. It's the opposite: I hope to motivate you to fiercely pursue a solid solution to your old-age income challenge. First, we’ll start with a realistic picture of the future, so you can bring your savings and your current lifestyle into line with it.
How much income will I have?
Knowing that retirement income generally has three sources—Social Security, a pension (maybe), and savings (perhaps supplemented with a post-retirement job)—it’s possible to estimate how much you’ll get upon retirement from these sources—but it’s not necessarily easy:
Social Security: At ssa.gov, you can check your earnings history and the estimated amount of your future monthly check. Remember, though, that amount assumes that your earnings history will continue on the same trend. If you take time off from work or are laid off, your Social Security benefit will adjust downward. If you get a promotion with a sizable raise, it’ll go up. Its size will vary significantly, depending on several factors. These include how old you are when you start collecting, how long you worked. In general, if you were a high earner and retired at age 70 in 2014, your Social Security benefit would be a bit more than $3,400 per month.
Your pension: In the average pension plan, a retiree will replace 2 percent of his or her income for every year worked (a 15-year employee would replace 30 percent, etc. ) Your estimate, then, will depend on how long you expect to have worked for your employer when you retire. However, policies vary: You may want to ask your HR representative to help you make this approximation.
Savings: It’s technically possible for you to use a compounding calculator to estimate how much money you’ll have accumulated in 20 or 25 years' time. But it's unwise. A compounding calculator will ask you for at least five things: the initial contribution (what you have in savings right now); your annual contribution, meaning what you earn; what you expect your raises will be; what percentage of your earnings you will contribute each year (if you use a compounding calculator, try to be realistic); and an assumed rate of return.
The rate of return is the part that can be a problem. Why? Most compounding calculators set a rate of return that’s too high, because investment fees aren’t taken into account. When you use a calculator, force down the assumed rate of return to 3 percent without inflation and 5 percent with inflation. I go a little lower, because, well, I’m an economist and I’m conservative on this issue. (A side note here: I like the AARP retirement calculator, because it calculates your Social Security benefit and you can change the assumptions easily.) Hey, what's the worst that can happen? If your returns outperform these cautious assumptions, you'll have enough money to improve your lifestyle in retirement, or you'll be covered if you live a little longer!
This is an excerpt from How to Retire with Enough Money and How to Know What Enough Is by Teresa Ghilarducci, published by Workman Publishing.
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