This is by far the most popular question that we come across as financial planners. You may have heard some of the "rules of thumb" like “80% of your current take-home pay” or “1 million dollars”.  In reality, the answer varies greatly on an individual by individual basis.  This article will outline the procedures that we follow as financial planners to help individuals answer this very important question.

Step 1:  Estimate Your Annual Expenses In Retirement

The first step is to get a ballpark idea of what your annual expenses might look like in retirement.    The best place to start is to list your current monthly and annual expenses. Then create a separate column labeled “expenses in retirement”.  Whether you are 2 years, 10 years, or 20 years away from retirement the idea is to pretend as if you were retiring tomorrow and determining what your annual expenses might look like.  Some of your expenses in retirement will be lower, others may be higher, but most people find that a lot of their current expenses will carry over at the same level into the retirement years. This is because most people have become accustom to a certain standards of living and they intend to maintain that standard of living in retirement. Here are a few important questions that you should ask yourself when forecasting your retirement expenses:

• How much should I budget for health insurance?

• Will I have a mortgage or debt when I retire?

• Do I plan to move when I retire?

• Since I will not be working, should I budget additional expenses for vacations and hobbies?

• Will I need to keep my life insurance policies after I retire?

Step 2:  Adjust Your Retirement Expenses For Inflation

Now that you have a ballpark number of your annual expenses in retirement, you will need to adjust those expenses for inflation.  Inflation is just a fancy word for “the price of everything that we buy today will gradually go up in price over time”.  If the price of a gallon of milk today is $2 then most likely 20 years from now that same gallon of milk will cost $3.51.  A 75% increase!!   Historically inflation has grown at a rate of about 3% per year.  There are periods of time when the rate of inflation grows faster or slower but on average it grows at 3% per year.

Another way to look at inflation is $20,000 in today’s dollars will not buy the same amount of goods and services 10 years from now because inflation erodes the purchasing power of your $20,000.  If I did my annual expense planner and it tells me that I need $50,000 per year in retirement to meet all of my estimated expenses, let’s look at what adjusting that $50,000 for inflation does over different periods of time assuming a 3% rate of inflation:

Today’s Dollars 5 Years From Now 10 Years From Now 20 Years From Now

$50,000         $56,275                  $65,238                    $87,675

In the above example, if I am retiring in 10 years, and my estimated annual expenses in retirement will be $50,000 in today’s dollars, by the time I retire 10 years from now my annual expenses will increase to $65,238 per year just to stay in the same place that I am in today.  Also, inflation does not stop when you retire, it continues into the retirement years. If I am 50 today and plan to live until 90, I have to apply this inflation adjustment for 40 years.  It’s clear to see how inflation can have a significant impact on the amount that you may need to withdrawal for your account to meet you estimated expenses at a future date.

Step 3:  Gather The Information On Your Current Assets

Once you know your expenses, you now need to gather all of the information on your retirement accounts and pension plans.  You should collect the most recent statement for all of your investment accounts (401K, 403B, IRA’s, brokerage accounts, stocks, etc.), pension statements (if applicable), obtain your most recent social security statement, and gather information on the other sources of income and/or assets that may be available when you retire. Such as:

• Sale of a business

• Downsizing the primary residence

• Rental income

• Part-time employment

Step 4:  Project The Growth Of Your Retirement Assets

There are three main categories to consider when calculating the growth rate of your retirement assets:

• Annual contributions

• Withdrawals

• Investment rate of return

For annual contributions, it’s determining which accounts you plan on making deposits too each year and how much?  For most individuals, their employer sponsored retirement plan is the main source of new contributions to their retirement nest egg.   If your employer makes regular employer contributions to your retirement plan, you should factor those in as well.  For example, if I am contributing 8% of my pay into the plan and my employer is providing me with a 4% matching contributions, I would reasonably assume that I’m adding 12% of my pay to my 401(k) plan each year.

The most popular question that we get in this category is “how much should I be contributing each year to my retirement account with my employer?”  We advise employees that they should have a goal of contributing 10% of their pay each year to their retirement accounts.   This is an aggregate total between your personal contributions and the employer contributions.   Even if you cannot reach that level right now, 10%+ is the target.

Let’s move onto the next category…….withdrawals.  Pre-retirement withdrawals from retirement accounts have become much more common in recent years due largely to the rising cost of college education.  Parents will take loans from their 401K/403B plans or take early withdrawals from IRA accounts to fulfill the need for additional income during the years that their children are in college.  If part of your overall financial plan is to use your retirement accounts to pay for one-time expenses such as college, you will need to factor that into your projections.

The third variable to consider when determining the growth of your assets is the assumed annual rate of return on your investments.  There are many items to consider when determining a reasonable annual rate of return for your accounts.  Some of those considerations include:

• Time horizon to retirement

• Allocation of your portfolio (stocks vs bonds)

• Concentrated holdings (10%+ of your portfolio allocated to a single investment)

• Accumulation phase versus distribution phase

The answer to the question: “what rate of return should I expect from my retirement accounts?”, can really only be determine on a case by case basis. Using an unreasonable rate of return assumption can create a significant disconnect between your retirement projections versus what is likely to actually occur within your investment accounts.  Be careful with this step.

Step 5:  Factor In Taxes

Don’t forget about the lovely IRS.  All assets are not treated equally from a tax standpoint.  For most individuals, the majority of their retirement savings will be in pre-tax retirement vehicles such as 401(k), 403(b), and Traditional IRA’s.  That means when you take distributions from those accounts, you will realize earned income, and have to pay tax.  For example, if you have $400,000 in your 401K account and you are in the 25% tax bracket, $100,000 of that $400,000 will be lost to taxes as withdrawals are made from the account.

If you have after tax investment accounts, it’s possible that you may owe little to no taxes on withdrawals.  However, if there are unrealized investment gains built up in your after tax investment accounts then you may owe capital gains tax when liquidating positons.

Also note, you may have to pay taxes on a portion of your social security benefit.   The amount of your social security benefit that is taxable varies based on your level of income.

Step 6:  Spend Down Your Assets

In the final step, you should run long term projections to illustrate the spend down of your assets in retirement.  Here are the steps:Example

• Start with your annual after tax expense number $60,000

• Subtract social security less taxes: ($20,000)

• Subtract pension payments less taxes (if applicable): ($10,000)

• Annual Expenses Net SS and Pensions: $30,000

In the example above, this individual would need an additional $30,000 after-tax to meet their anticipated annual expenses in Year 1 of retirement.  I stress “after-tax” because if all of the retirement assets are in a pre-tax retirement account then they would need to gross up their distributions for taxes to get to the $30,000 after tax.  If it is assumed that $40,000 has to be withdrawn from an IRA each year, the 3% inflation rate is applied to the annual expenses, and the life expectancy of this individual is 20 years from the date that they retire, this individual would need to withdrawal $1,074,814 out of their retirement accounts over the next 20 years to meet their income needs.

Step 7:  Identify Multiple Solutions

There are often times multiple roads to reach a destination and the same is true when planning for retirement. If you find that you assets are falling short of the amount that is needed to sustain your expenses in retirement, you should work with a knowledgeable financial planner to identify alternative solutions.  It may help you to answer questions like:

• If I decided to work part-time in retirement how much would I have to earn?

• If I downsize my primary residence in retirement how does this impact the overall picture?

• If I can’t retire at age 63, what age can I comfortably retire at?

• What are the pros and cons of taking social security benefits prior to normal retirement age

I also encourage clients to spend time looking at their annual expenses.  If you find that your are cutting it close on income versus expenses in retirement, it's usually easier to cut expenses than it is to create more income in the retirement year. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.