With retirement looming just around the corner for a large part of the population, and with countless articles detailing just how few of us will have enough set aside, a question that increasingly crops up is, “How much money do I need to retire?”
Although the answer depends largely on how well you and your partner want to live in retirement, how long you live, and how healthy you are while you’re alive, you can use a widely accepted methodology among financial professionals to get a ballpark idea of where you stand. You can also figure out how much more you need to set aside monthly to help make up any shortfall.
The methodology comes down to this:
- Estimate retirement income needs.
- Estimate retirement income resources.
- Determine your retirement income gap (RIG) by subtracting (2) from (1).
- Estimate savings necessary to bridge the RIG.
Retirement Income Needs
Consider an example where current annual expenses are $72,000, but only 70 percent of that—$50,400—is needed in retirement. Assuming an inflation rate of 3 percent and 10 years remaining until retirement, a $50,400 annual retirement income need today grows to $67,733 by retirement. Assuming that inflation continues at 3 percent postretirement, that principal is liquidated, that investments earn 6 percent after taxes, and that retirement income is needed for 20 years, the total capital needed to fund the retirement income need is $1,045,480.
Retirement Income Resources
Retirement income derives from three sources:
- Private savings
- Employer-sponsored programs
- Government-sponsored programs
Tally up how much you have set aside for retirement in savings accounts, certificates of deposit, life insurance cash values, annuities, money market funds, mutual funds, and individual stocks and bonds as well as traditional and Roth IRAs.
Next, look at the annual benefit statement from your employer. This statement discloses your account balance in 401(k) and profit-sharing plans and tells you about how much you can expect to receive from defined-benefit pension plans. Find out whether your plan would distribute these funds to a domestic partner in the event of your death.
Also visit the Social Security Administration website. There you can get an estimate of your monthly benefit if you retire at any time between age 62 and your full retirement age (also called “normal retirement age”).
Add your private savings and account balances from employer-sponsored plans together. Also, add up how much annual income you expect from pension plans and Social Security at retirement age.
To make an apples-to-apples comparison of retirement income needs to retirement income resources, you must project the value of assets earmarked for retirement to your retirement age. Also, you need to discount Social Security and pension benefits to a capital amount at retirement.
Say you had $50,000 in a 401(k) plan and $40,000 in mutual funds. Ignoring future contributions and assuming a hypothetical 6 percent after-tax return, these resources would grow to $161,176 in 10 years (this would be reduced by income tax on the portion of the $50,000 in the 401(k) plan that was not previously taxed). This is referred to as the future, or projected, value of these assets.
Furthermore, if you expected $14,000 annually for 20 years from Social Security, $9,600 annually for 20 years from an employer pension, and assumed a discount rate of 6 percent after taxes, these income streams are worth $270,690 at retirement. This is referred to as the discounted, or capitalized, value of these income streams.
Now, add the future value of your private savings and account balances from employer-sponsored plans to the capitalized value of your Social Security and pension benefits at retirement age. Together these amounts are your total retirement income sources.
For example, when the $161,176 projected value of 401(k) and mutual fund assets is added to the discounted value of Social Security and pension benefits—$270,690—total retirement income resources amount to $431,866.
The Retirement Income Gap
Once you’ve calculated the capital value of your retirement income need and retirement income resources, it’s a simple matter to determine the retirement income gap (RIG). The RIG is simply the difference between needs and resources.
In the example, retirement income needs were $1,045,480; retirement income resources were $431,866. The RIG is the difference—$613,614.
More than $600,000 is a lot of ground to make up with only 10 years left until retirement. At this point in the process, many people seek the help of a licensed financial professional. He or she can help you bridge the retirement income gap. He or she can also recommend appropriate products based on your risk tolerance, investment objective, and time horizon.