Many people have no idea how much they should be saving for retirement and thus quite often they do whatever their retirement counselor suggests without actually knowing if what they’re doing is right. I wanted to understand the full process better, so I spent some time figuring out what I would need for retirement and doing the math on it – no investment knowledge required.
How old will I be when I actually start drawing retirement benefits? That’s a question you need to ask yourself. It’s not exactly the same as “when will I retire?” because, for example, I never plan to actually “retire” in the traditional sense. I will always have some sort of business or activity going until I’m literally incapable of doing anything at all. For me, though, I’m targeting age 62 to start getting out benefits.
How many years will I actually live after retiring? I used a life expectancy calculator to get a very thumbnail approximation of my age to start with. However, this number is flawed in a lot of ways – the younger you are, the more likely it is that medical techniques will extend your life. Plus, it’s only a rough number.
To account for medical advances, I take the number that calculator spits out (for me, it was 70), subtract my age from it, then round that number to the nearest 5. The number I got was 40. Then, divide that number by five, leaving 8, then add that to the age estimation, giving 78. Why divide this by five? The average life expectancy of an American over the last hundred years has gone up roughly a year for every five years that pass. The younger you are, the more likely medical advances will benefit you.
Since this is just an “average” estimation, I also add on half a standard deviation of the normal lifespan, which means add nine years to your earlier number to cover yourself if you exceed the statistical average of how long you should expect to live. This would bump me up to 87.
Then, take this final age calculation and subtract your retirement age from it. I want to “retire” at age 62 and start drawing my benefits, so that means I’ll have 25 years of retirement that need to be covered.
How far are you from retirement? Take the age you want to “retire” and subtract your current age, rounded to the nearest year. This leaves me with 34 years to retirement.
How much will you need your first year in retirement? I don’t believe that Social Security will be a factor at all in my post-retirement income, so I figure what I’ll need without it. My belief is that I’ll want 75% of my current salary each year in retirement, so how much will that be the first year I retire? If I make $50,000 now, 75% of that would be $37,500. Over the last two decades, inflation has been somewhere around 3%, so we also need to figure in 34 years of inflation (that’s how many years I need to retire). Using a basic compound interest calculator, with a current principal of $37,500, no annual addition, 34 years to grow, and an interest rate of 3%, I get a value of $102,446.45. That’s how much I’ll need the year I retire to have 75% of the value of my salary today. Wow.
How much will you need during your whole retirement? Since my investment will still be growing at retirement, I figure that I just need the first year’s dollar amount for the number of years I’m in retirement. That would be $102,446.45 times 25 years, or $2,561,161. I have 34 years to get there.
How much can I afford to put away? If at all possible, you should always put away the maximum amount that you can into your retirement plan; that way, you don’t absolutely need spectacular returns in order to retire. For me, I can put away up to 15% of my salary ($50,000) into a retirement plan, so I put away $7,500 each year.
What retirement plan do I pick? This is the trickiest math part. Fire up that basic compound interest calculator again and plug in how much you currently have in retirement as your current principal, the amount you’re socking away each year as your annual addition, your years until retirement as your years to grow, and 4 as the interest rate. After you hit calculate, the calculator will spit out a “future value.” What you need to do is keep raising and lowering that interest rate until you find a rate that, when you hit calculate, the future value is close to what you need to have for retirement. For me, that was 9%.
Once you have that percentage, get ahold of the person who manages your retirement and ask for help in choosing a package. Tell them that you did the math on your own and you need to have a specific return in order to retire. Ask them which investment plan is most likely to average that level of return over the long haul.
Some people will note that if you put 15% of your salary away every year, your annual addition will increase each year. That’s absolutely correct – I view that extra money as breathing room so that if the return isn’t quite as strong as you hope, it won’t dash your plans.
That’s it. Just start pumping money into the plan just like that and just forget about it until you need it. This is exactly what I’m doing – I’m putting away my 15% into my retirement plan after picking a Target Retirement one that worked for me and I’m just sitting on it and forgetting it.