Estimating Your Retirement Needs

The purpose of financial planning for retirement is simple — to ensure that you have a financially comfortable retirement. But remember, financial planning is not an exact science. You are dealing with uncertainty and will have to make various assumptions and estimates. These assumptions and estimates can be made based on reasonable and educated judgments about what may happen in the future. As time passes and more information becomes available, you will change your assumptions and estimates and adjust your investment strategy to accommodate the changing environment.

The first step is to determine what you will need and want during retirement and what amount of income will sustain that lifestyle. One method is to prepare a detailed proposed budget of your living expenses during retirement. Consider such items as housing, food, clothing, transportation, insurance, taxes, leisure and recreation costs, medical expenses, and savings. You may want to analyze your current spending habits, and then identify which expenses would decrease during retirement (such as clothing and commuting costs) and which would increase (such as leisure and recreational activities). This is a good method for those who are fairly close to retirement, and who can therefore make fairly accurate budget assumptions.

An easier way to plan for retirement, particularly for those who are under 55 or so, is to state your retirement income objective as a certain percentage of your preretirement income. Many retirees live on anything from 60 percent to 80 percent of their preretirement income. It's usually better to plan at the high end of the range to allow yourself flexibility should your investments not work out as you hoped.

For example, suppose you are a 45-year-old, single male who intends to retire at age 65. You estimate your annual retirement needs at 80 percent of your preretirement income of $60,000. You also estimate that your social security benefits will amount to 20 percent of your current salary. (The Social Security Administration can provide you with a more accurate estimate upon request.)

A quick computation would result in the following:

Retirement Needs Computation
Current annual salary	$60,000
% of current salary to be replaced	x 80%
Annual retirement income target	$48,000
Minus: Employer-provided pension benefits	(21,000)
Minus: Social security benefits (assume 20% of salary)	(12,000)
Required annual income from savings and investment funds	$15,000
Life expectancy — years of retirement (determined by reference to insurance tables)	x 15 years
Required target savings and investment fund needed at retirement	$225,000
Minus: Current savings and investments:
Individual Retirement Account	(20,000)
401(k) Plan	(50,000)
Savings account	( 5,000)
Other investments	(25,000)
Required additions to savings and investment fund	$125,000
Years to retirement (retirement age - current age)	20 years
Current annual savings required to reach savings and investment fund target	$ 6,250

Notice that this calculation is based on current dollars. For ease of computation, we'll assume that the positive investment return on the funds saved and the negative effect of inflation on the savings are approximately equal. If, in fact, your retirement goal is at least 5 years in the future, you should consider higher-risk investments that have a greater potential for yields that significantly beat the inflation rate over the long-term.