When determining how much money you need to accumulate to enjoy your idea of a comfortable retirement, you can use several methods. The easiest is to go with a number that financial planners think will be needed for a secure retirement, say $ 1.3 million dollars. The next easiest is to use a formula. One popular formula is based on a multiplier of your current wage. That multiplier ranges from 15 times your current annual wage to 22 times your current annual wage, depending on the source. A third way is to target the amount of income your retirement assets will need to produce. In other words, in addition to a company pension, if any, and Social Security, how much additional income will you need to maintain the standard of living you want in retirement. Once you have estimated that amount, you then calculate how many dollars of retirement assets it will take to produce that income given what you consider to be a reasonable return on those assets. The result is your retirement savings number.
Targeting retirement income keeps it real
I prefer targeting retirement income because it keeps you in reality. After all, retirement income is the whole point of saving for retirement; it is not how much you have accumulated, but how much income it can produce that counts. This is an important distinction, because it is easy to get distracted by large amounts of money as your retirement assets grow. People most often talk of the amount of money they have in retirement savings when they talk to me about retirement security. They think two or three hundred thousand dollars in retirement savings is a lot of money. When I point out that two or three hundred thousand dollars in retirement savings will only produce $8,000 to $12,000 in annual retirement income, they are often shocked and surprised. Suddenly, what seemed like a large sum of money isn’t so large anymore. Don’t get me wrong, two or three hundred thousand dollars is a large sum of money, but not when someone needs $20,000 or $30,000 a year to supplement pension and Social Security income. In reality, it is a good start. Unfortunately, these people are often in their late fifties or early sixties with limited time to add to their retirement savings.
The truth is most people save all of their lives for retirement but don’t really know what they are saving for. They assume that because they have accumulated hundreds of thousands of dollars it will be enough money to secure their retirements. Not until they are at the threshold of retirement do they consider just how much income they will need in addition to pensions and Social Security to maintain their standard of living. Often they come up short. True they have accumulated a large nest egg, but it isn’t nearly large enough.
Targeting retirement income accounts for change
Another reason to target retirement income is change. The amount of money you will need in retirement is likely to change many times as you progress through life. Your standard of living, your values, and your income will probably change over your working life. Living standards and income may go up or down or up and down. Rosa and I certainly experienced those types of changes. What you value may change, as well. You may become more materialistic or less. You may decide to settle for a more modest standard of living and retire early, or work additional years beyond traditional retirement to enjoy a more lavish lifestyle when you retire. Don’t forget external changes such as the rate of inflation, changes to pension plans, changes to Social Security benefits and Medicare that will affect the amount of supplemental retirement income you will need. As your estimated retirement income changes over the years, you can adjust your retirement savings number accordingly.
Don’t forget inflation
When estimating your retirement income, consider inflation. It’s not how much income you will need the day you retire, but how much you will need ten, twenty, and even thirty years down the road. During your working life, you have received periodic merit and cost of living raises that insulated you from the cost of inflation In retirement, you will live on a fixed income. With each passing day, your cost of living will increase while your income remains the same. There may be cost of living increases to Social Security, but these have proven to be far from adequate to keep up with inflation.
You must be proactive and plan for inflation in retirement so you have the assets necessary to generate enough income to offset the effects of inflation during your retirement years. Use the rule of 72 to quickly determine your cost of living in the future. Divide 72 by the rate of inflation and that will tell you how many years it will take to double your cost of living. For example, with a 2% inflation rate, it will take 36 years for your cost of living to double (72 divided by 2). At a 3% rate of inflation, your cost of living doubles in 24 years (72 divided by 3).
Retirement calculators can help
Retirement calculators can help you estimate the retirement income you will need and how much money it will take to generate that income while accounting for inflation and taxes. Here are some calculators to try: Bankrate Retirement Income Calculator, Bankrate Retirement Planner Calculator, The Real Deal Retirement Toolbox (numerous retirement calculators).
Rosa and I have always thought of savings in terms of the income it could produce and it has served us well. Of course, our goal from the beginning was financial independence which required income to replace wages. Most people equate retirement with financial independence and they are correct in doing so, but only if they have enough retirement income to support themselves without working in retirement. It is all about income, so target retirement income when determining your retirement savings number.
K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages