Preparing for retirement involves a lot of guesswork. Anyone who tells you otherwise is either uninformed or selling something.
Think about it for a minute. Can you predict what will happen next year? How about what you will be doing in 5 or 10 years? New college graduates need to look 30 or 40 years into the future. It can't be done. But that doesn't mean retirement planning is impossible. You just have to realize there are many unknown factors which need to be considered. Here are three estimates you need to make to plan for retirement.
How much will your investments earn? Many financial analysts and talking heads are quick to point out that stocks have returned roughly 11 percent per year since the Great Depression. That may be true, but the past doesn't predict the future. And the 11 percent was average growth, not linear growth. There is a big difference. For example, in some years the stock market as a whole may have grown 20 percent, then dropped 30 percent the next year. Then it may have taken 5 more years to get back to the original level. These ups and downs can have a major impact on your decision to retire in any given 5 or 10 year period. Just look at the stock market as a whole over the last decade. I know many people who had to delay retirement because their investment portfolio took a big hit and it took longer to recover than they anticipated it would.
What will your tax bracket be? Ben Franklin wrote, "'In this world nothing can be said to be certain, except death and taxes." Mr. Franklin was a wise man. The only thing we can predict about our future taxes is that they will be around. Why is this important? Taxes have a major affect on retirement planning. Take, for example, Traditional and Roth IRAs. Both offer distinct tax advantages: A Traditional IRA is good for a tax break now, while the Roth IRA gives you a tax break in retirement.
Tax brackets also affect your non-retirement income. The projected 2011 tax brackets show an anticipated increase in long-term capital gains taxes, an increase in the top income tax bracket, and other changes which will affect our income and investments now, and potentially years from now.
How high will inflation be? Inflation is another unpredictable factor for retirement planning. About the only thing we can say is that it will be present. The hope is that our income and investments will not only keep pace with inflation, but exceed it. You can also devote a portion of your portfolio to capital preservation by using government bonds such as TIPS and I-Bonds, which are a reasonably safe way to prepare for inflation.
Even the best calculators aren't 100 percent accurate. It's easy to build a mathematical model. But in real life, numbers aren't always around, and they certainly aren't predictable. The problem with online calculators is that many are built to only calculate in a straight line, and the stock market certainly doesn't act in a straight line. Use calculators for a back of the envelope estimate, but don't treat the results as a guarantee. Try playing around with your estimates and use several rates of return to get an idea of how your investments could perform.
[See How to Retire a Millionaire.]
What you can do now. I have two suggestions which should help with retirement planning: Contribute more than you think you need and be conservative in your estimates. Saving more than you estimate you need gives you options down the road. If your investments don't meet expectations, then hopefully your additional contributions will help you reach your retirement goals. If you overshoot your goals you may be able to retire earlier or enjoy a higher standard of living than you had anticipated.
Being conservative in your estimates helps you prepare for the unknown. Don't plan on earning 10 to 15 percent on your investments. It may not happen. Instead, try using a more conservative number such as 6 percent or 7 percent. Planning conservatively allows you to prepare for a worst case scenario and be pleasantly surprised if your investments exceed your calculations.