Determining how much we need to accumulate for retirement is a simple, four step process. But, to do-it-yourself you will need a financial calculator and make correct assumptions about inflation and investment returns.
Realistic, even conservative assumptions is better than what we’ve experienced in the recent past. This is not a one-and-done exercise. It’s ongoing to and through retirement.
In this article we’ll walk through the steps to determine how much we will need at retirement, relying on what we consider to be reasonable assumptions as of today. In other words, we’ll focus on the concepts. Ongoing management is a perpetual process that’s necessary to get you to the comfortable retirement you desire.
Calculate how much retirement income will you need each month?
The rule-of-thumb is that you will need at least 70% of your current monthly income during retirement. We refer to this as your “target retirement benefit”.
For example, if you currently make $3,000 per month then you will need $2,100 per month during retirement ($3,000 x 70%).
How much will your social security benefit be at retirement?
Social security provides a substantial benefit at retirement, but it probably isn’t enough to completely cover your monthly income need.
If you work to your Normal Retirement Age (defined by the Social Security Administration, and based on your date of birth), social security is expected to replace a portion of your current income. However, the higher your annual income before retirement, the less you should expect in social security benefits.
For example, if your pre-retirement annual income is $40,000, social security will replace about 51% of it at retirement. But, if your pre-retirement income is $80,000, social security will only replace about 42% at retirement. The higher your income the less in social security benefits at retirement.
The Social Security Administration has a great calculator to estimate your monthly benefits.
Here’s the link: https://www.ssa.gov/OACT/quickcalc/index.html
What’s the difference?
The difference is the “funding gap” that will need to come from our retirement savings, other sources of income or investments.
For example, if our desired retirement benefit is $2,100 per month and social will provide $1,500 per month, the funding gap is $600 per month.
Calculate the future value of the funding gap?
Now that we have determined the monthly income we will need from our retirement account or other investments ($600/month), we need to calculate the lump sum needed at retirement. Don’t forget to factor in inflation.
A good rate of return assumption that is already adjusted for inflation is 3.5%. This is also know as the real rate of return.
To Summarize, Doing the Math
Pre-retirement monthly income
70% target retirement benefit
Expected social security benefits
Funding Gap
Target Lump Sum at Retirement
$3,000
$2,100
-$1,500
$600
$219,000
Assumptions: 20 years from retirement, 2.5% inflation, 30 years in retirement, 3.5% real rate of return during retirement.