When it comes to retirement planning, most of us are consumed by figuring out “the number” – that elusive savings goal we aim to hit by age 65, or there about.
Figuring out how much to save for retirement can be confusing, to say the least. You’ve got to factor in your current income, your retirement lifestyle expectations, inflation, income growth, returns and possible Social Security checks. To complicate matters, different financial planners and accountants recommend different calculations to find “the number.”
Each calculation approach has its own pros and cons, and each will probably lead you to a different retirement goal. It’s up to you to decide which approach or combination of approaches works best for your needs so that you can calculate your own retirement plan.
Keep in mind that there are top-down and bottom-up approaches to retirement goals. The top-down approach attempts to determine how big your nest egg will need to be at retirement, such as 25 times your annual expenses. The bottom-up approach seeks to determine how much you’ll need to save each year to reach your goals, perhaps 15 percent of your salary.
Think about lifestyle first. Most retirement calculations assume you’ll want to live a similar lifestyle to the one you’re currently in once you retire. But because you’ll generally have fewer expenses, like payroll taxes, work expenses and (hopefully) debt payments, you probably won’t need to withdraw 100 percent of your current income during your retirement years.
The U.S. Department of Labor estimates that most retirees need about 70 percent of their pre-retirement income during retirement, though lower-income earners may need 90 percent or more of pre-retirement income. If you plan to travel and live it up, you’ll need more, but if you plan to live a quiet, simple life at home, you may get by easily on less.
The point is that each of these approaches hinges on the question of what kind of lifestyle you want to lead in retirement, as this will have a huge impact on how much you need to save.
1. The “quick and dirty” approach. The “quick and dirty” approach described in this Kiplinger article is a very basic way of planning for retirement. Even though it’s pretty simple, this approach can actually help you set realistic goals and motivate you to work towards them.
These formulas generally take Social Security into account, and make some basic assumptions that your salary will rise faster than the rate of inflation and your retirement accounts will meet basic return-on-investment thresholds, usually of around 5 or 6 percent.
Generally, these formulas simply set a savings goal based on saving anywhere from seven to 20 times your current annual salary. A benchmark of 11 times your salary is a commonly used estimate within this range.
2. Safe savings rates. Recently, an associate professor at the National Graduate Institute for Policy Studies in Tokyo, Japan, Wade Pfau, proposed an interesting new theory for calculating retirement savings. While most other methods focus on minimum withdraw rates during retirement, the safe savings rates method focuses more on how much, at a minimum, you should save for retirement.
Pfau suggests creating savings guidelines that are based on historical data about the stock market. According to his article in the Journal of Financial Planning, this method treats “the number” and withdrawal rates “as almost an afterthought.” Instead of focusing on meeting a particular end goal, you focus on following a strict savings plan. Pfau’s tables can give you an idea of what percentage of income to save for retirement, based on your age.
3. Age-based goals. Age-based retirement savings goals do focus on the end number, but this method of calculation actually gives you several smaller numbers along the way. These benchmarks help you see if you’re on track for retirement savings, or if you need to ramp up your savings to hit your final goal in time.
Age-based benchmarks are often based on either a very complicated retirement goal calculation or on a “quick and dirty” calculation like the ones outlined above. One popular age-based goal list is from Fidelity Investments and suggests benchmarks like saving your annual income by 30, 3 times your annual income by 45 and 6 times your annual income by 60. Like end-goal quick calculations, this formula from Fidelity has some built-in assumptions, like having a 401(k) plan, retiring at 67, portfolio growth of 5.5 percent and no breaks in employment or saving.
4. Complex retirement calculators. The above three options for finding your retirement number are relatively simple and straightforward. This isn’t necessarily a bad thing, but many of us would prefer a little more detail. In this case, there are a plethora of complicated retirement calculators that take everything from income goals to Social Security checks to inflation to annual interest into account before setting a retirement goal.
This article from Fox Business shows one possible way of calculating your number. The article’s author asserts that the math isn’t that hard (though it still doesn’t take all the details into account), but it’s still more complicated than most of us can handle on our own.
No option is perfect. Most financial planners will tell you that figuring out a retirement goal is more art than science. In the end, you’re really just making an educated guess, since none of us knows exactly what the market will look like in ten months, let alone ten or more years.
When you’re covering decades’ worth of financial information and assumptions with a single calculation, expect things to get a little messy. But don’t let that discourage you. Instead, let it motivate you to save as much as you can, so that you’ll be secure during your golden years.
Rob Berger is the founder of the popular personal finance blog, the Dough Roller.