How-to Guides

Picturing yourself as a retiree may be hard if not impossible. But if you could envision those future years, you'd probably see a life full of activity and decades of health, happiness, and prosperity. No rocking chairs and lap shawls need apply.

The reality, however, is probably somewhere in between. The problem with the picture is that the pleasure and comfort of your later years depend, to an ever-increasing degree, on the actions you take today.

So many changing facets of the American workplace have made it more important than ever to take control of your financial future. By investing now with a long-term focus, you can greatly improve your chances of having a fulfilling retirement.

Americans used to count on a pension plus Social Security to get them through those "golden years." These days, people change jobs more often, rely on dual incomes, and manage their own retirement funds through defined contribution plans. By most estimates, you'll need between 60% and 80% of your final working years' income to maintain your lifestyle after retiring.

Sources of Retirement Income



This chart represents the income sources of American retirees.
Source: Social Security Administration, 2006.
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The accompanying pie chart shows the importance of saving now toward a retirement fund. Not only are Social Security benefits less significant, but the sums are diminishing and the age at which you can begin to receive benefits is higher. You can contact Social Security at 1-800-772-1213 to learn what you can expect in benefits, and when. Benefits are calculated on your earnings, with certain variable factors.

Alas, the responsibility for the bulk of your nest egg rests with you. Social Security represents approximately 39% of the typical retiree's income, according to the Social Security Administration.

Also, as you begin thinking about how much you'll need for a comfortable retirement, you may be startled to learn the impact of inflation. At an average inflation rate of 3%, your cost of living would double every 24 years. Your annual income will need to increase each year even during retirement in order to keep up with the gradual rise in prices of everyday goods.

You'll also have to consider the likelihood of increased medical costs and health insurance as you grow older. The average nursing home stay, for instance, now costs more than $74,000 a year and could rise to over $150,000 per year by 2030, assuming an annual inflation rate of 3%.
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Financial experts estimate that most people will need anywhere from 60% to 100% of annual pre-retirement income to live on each year after retirement. To find out how close you are to accumulating this amount, complete the exercise below.

1. Estimate your last working year's salary. Multiply your current salary by the inflation factor from Table 1, based on the number of years you have until retirement. This represents the future value of your salary, assuming 3% annual inflation.
   
   Example: If you are currently making $40,000 and have 20 years until retirement, your formula is $40,000 x 1.81 = $72,400



2. Determine the percentage of your last working year's salary that you expect to need for annual living expenses after retirement. If 100% seems high, consider that while you may be able to reduce some expenses, such as commuting costs, others, such as health care, may increase. Multiply the percentage of your last working year's salary that you expect to need by the amount in #1.
   
   Example: $72,400 x .80 = $57,920



3. Estimate your future Social Security and retirement benefits. The best source for Social Security benefit projections is your annual Social Security statement (or one of the calculators from www.ssa.gov). If you don't have access to these, you can estimate your benefit using Table 2.
   
   a. From your Social Security Benefit Statement, multiply the monthly amount listed under "If you continue working until full retirement age") by 12, then multiply that figure by the inflation factor from Table 1.
   
   Example: If your benefit statement shows an estimated monthly benefit of $1,153 and you expect to continue working an additional 20 years, your formula is $1,153 x 12 x 1.81 = $25,043
   
   b. If you are using Table 2, take the number corresponding to your annual salary and years to retirement.
   
   Example: If you currently earn $40,000 and have 20 years to retirement, your estimated benefit would be $25,000



4. Subtract your Social Security benefits and other retirement benefits from the amount calculated in #2. This will give you an estimate of how much income from your personal assets you are likely to need each year in retirement.
   
   Example: $57,920 - $25,000 = $32,920



5. Estimate the total amount that you will need in retirement accounts (such as 401(k) plans and IRAs) and personal savings. To determine this amount, multiply 19.3 by the annual amount you calculated in #4. This answer represents the amount of savings you are likely to need to last 28 years, assuming a 3% annual inflation rate and a 6% annual investment return during retirement. A healthy, 65-year-old male has a 10% chance of living longer than 28 years.
   
   Example: $32,920 x 19.3 = $635,356



6. Enter the amount of your current savings and investments and multiply it by the growth factor from the accompanying table. This is the amount that your savings would likely be worth by the time you reach retirement, assuming an 8% annual investment return prior to retirement compounded annually.
   
   Example: $30,000 (account balance) x 4.66 (growth factor for 20 years until retirement) = $139,800



7. If line 5 is larger than line 6, congratulations! You are likely on your way to meeting your retirement savings goal. Keep saving! If line 6 is larger than line 5, subtract line 5 from line 6. Enter that amount here. This is the additional amount you'll need.
   
   Example: $635,356 - $139,800 = $495,556



8. Divide #7 by the multiplier in Table 1 that corresponds to the number of years until your retirement. The multiplier represents how large your savings are likely to grow based on your annual contribution to qualified retirement accounts. The result is the approximate amount you may want to set aside each year.
   
   Example: $495,556 / 49.42 = $10,027

Traditional pensions are estimated to supply less than 19% of retirement needs, according to the Social Security Administration (2004; most recent report published).

Add that to the 39% or so a year you might expect from Social Security, and you'll probably still fall far short of your goal. A radically reduced standard of living for a quarter century or more is hardly the stuff "golden age" dreams are made of.

Fortunately, you have some allies. First is the power of compounding, which takes advantage of time. Tax deferral is another ally. Using investment vehicles such as 401(k) plans or individual retirement accounts (IRAs), you can put off paying taxes on your earnings until you are retired and potentially in a lower tax bracket. Meanwhile, your contributions may be pretax or tax deductible, helping reduce current tax bills.

For example, an investment of $10,000 would grow to more than $100,000 after 30 years, at an annual return of 8%, if all the returns were reinvested and the account grew tax deferred. As with all hypotheticals, this example does not represent the performance of any specific investment and the earnings would be subject to taxation upon withdrawal at then-current rates and subject to penalties for early withdrawal.

The more time you have until retirement, the more fortunate you may be. Delaying just months -- never mind years -- can significantly reduce your results. Consider this example: Jane begins investing $100 a month in her employer-sponsored 401(k) plan when she's 25. Mark does the same -- beginning when he's 35. Assuming a 9% annual rate of return compounded monthly, when Mark retires at 65, he'll have $183,074. Jane will have $468,132.

While this is only a hypothetical and there are no guarantees any investment will provide the same results, you can see the remarkable difference starting early can potentially make.

By starting early, investing systematically, and benefiting from the potential of compounding and tax deferral, you may pack a lot more punch into your portfolio.

Another advantage of today's retirement planning options is that you can control how your money is invested.

Investment plans need to be customized because different people have different degrees of risk they will accept as well as varying time frames they intend to hold their investments. A tailor-made portfolio can be diversified to take these factors into account. It's a wise idea to consult a professional financial advisor for complete information.
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