From the time most Americans begin their careers, there exists constant talk about saving for retirement. And it’s not just our friends and families. Companies, too, push retirement on their employees by offering everything from defined benefit plans to various defined contribution plans.
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But despite all the talk about preparing for retirement, Americans have never been less prepared to walk away from their jobs. Incredibly, about half of American households have no retirement account at all. Worse, the Government Accountability Office (GAO) reports that nearly one-third of American households age 55 and older have neither a retirement plan nor a company pension.
But Americans with retirement plans aren’t much better. One-third of Americans with retirement plans have just $5,000 saved. Even older Americans who have worked for decades have an average of $172,000 saved for retirement. Let’s put that in perspective — $172,000 at today’s rates would generate about $5,100 annually — or about $430/month before taxes.
Most Americans don’t save enough for retirement because they have no clear idea of how much money they’ll need to meet their goals. And it’s this uncertainty that keeps their efforts to save muddled and unclear. In that light, here are the three steps every American needs to understand in order to plan a successful retirement.
The first step in planning a retirement is to determine how much money a retiree will need to maintain their standard of living. To do this, multiply your expected or desired income by 80%. In other words, if you expect to retire on $62,500/year, multiply $62,500 by 80% to get $50,000. This is how much income you will need in retirement to maintain your standard of living. Once the income is determined, we’ll adjust this number to inflation.
Inflation is an insidious enemy of savers. Inflation causes the dollars in your pocket today to buy fewer goods and services in the future. As such, any attempt to plan for retirement must account for the devastating effects of inflation.
The average long-term inflation rate in the U.S is 3.2%. Now, if you believe, as I do, that future inflation rates will be higher, a rate of 5% is a conservative estimate for the future.
Here’s where retirement planning gets intimidating for many Americans who thought they’d never use algebra outside of high school. We have to adjust our annual income to inflation using the following formula:
FV = P(1+r) n
First, let’s define the terms. FV represents the future value of your income. P is your desired or expected income, while r is the expected inflation rate. Lastly, n represents the time (in years) before retirement.
You won’t need a financial calculator to do the math. All smartphones have the built-in capacity to do this calculation if you turn the phone sideways when using the calculator app — just look for the xy function.
Let’s do a practice calculation. Let’s assume you need $50,000 annually in retirement to maintain your current standard of living. You expect to retire in 40 years and believe inflation will average 3.2% over that time.
The math looks like this…
FV = $50,000 (1+.032) 40
On your smartphone, take 1.032, then hit the multiplication sign. Next, tap the xy button. Then, type 40 for the years, then the equals sign. In this example, that comes to 3.52. Multiply 3.52 by $50,000 to get $176,000 (rounded). This is the annual income needed in 40-years to buy what $50,000 buys today. If you expect 5% inflation, an annual income of $352,000 is required.
The final step is the hardest. That’s because once the income need has been identified, we need to save enough to generate the necessary revenue.
Of course, not all the future income will come from a retiree’s savings. Some will come from pension income, and of course, Social Security. Speaking of Social Security, it’s important to remember the program is in serious trouble and will likely supply less than 20% of income for most Americans under age 50 today.
Subtracting the 20% of Social Security income, and another 20% from a company pension, our retiree will need to generate another $106,000 annually from their savings. Now, let’s assume a saver can earn 8% annually on their investments over the long haul (the stock market return is 7 – 9%, adjusted for inflation). At 8%, a saver will need to create a nest egg of roughly $1,325,000 ($106,000/.08) to generate the income.
So how much does a saver need to invest in a retirement plan to save $1,325,000 in 40-years? To calculate the monthly payment, we simply alter our original formula to:
Payment = (FV x r) / [(1 + r) n – 1]
Because we will assume quarterly compounding (most stocks pay dividends quarterly), we must divide the interest rate by four and multiply the compounding periods by four as well. So, the interest rate will be .02 and the time will be 160 quarters in this example.
The math looks like this…
Payment = (1,325,000 X .08) / [(1 + .02)160 – 1]
= 106,000 / [23.77- 1]
= $106,000 / 22.77
= $4,655.25 annually, or $388/month
There are many variables in retirement planning. But at the end of the day, the three steps outlined above will solve the most basic retirement planning questions about how much money you need.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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