Imagine planning for a vacation you'll be taking some 20, 30 or even 40 years from now. You don't know where it will be, how much it will cost or how long it will last, but you're tasked with saving a chunk of every paycheck toward that trip until the day you embark on it. You're not even sure how much to save or when you have saved enough. Crazy, huh?
Welcome to the world of retirement planning, in which everyone younger than retirement age is expected to anticipate future expenses, figure out the amount that will cover those costs throughout old age, and save like mad until they hit the magic number. Unlike previous generations, for whom employers did some of the saving in the form of pensions, current and future generations must sock away most or all of the savings themselves.
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Not surprisingly, researchers, financial institutions and financial planners offer to help you set that amount, from multiples of final salary to percentages pegged to your preretirement income. But no one formula fits every person or life stage, says Steve Utkus, director of the Center for Retirement Research at Vanguard. "The further away you are from retirement age, the more uncertain the model."
Still, retirement formulas do help you focus on what you need to do, says Chuck Yanikoski, who developed RetirementWorks II, a financial-planning tool for people near or in retirement. Retirement benchmarks also keep you from overshooting or undershooting the mark. "A lot of people are stressed who don't need to be, and others are cheerfully heading into disaster," says Yanikoski. "Either way, you're better off knowing where you are."
Calculate your target
No matter what your age, you should have at least some idea of how much income you'll need in order to maintain your standard of living once you're out of the workforce. Retirement analysts generally set the number at 70% to 85% of preretirement household income. That's not because you'll be expected to skimp in your old age, but rather because some costs, such as payroll taxes, money set aside for retirement saving and work expenses, will disappear and others, such as your income taxes, could drop.
To keep it simple, Fidelity arrives at the 85% replacement rate by multiplying your final salary by eight. The calculation includes Social Security but doesn't factor in dual incomes; it assumes you'll retire at 67 and spend down your nest egg over 25 years. Fidelity also gives you savings mileposts: Save one times salary at age 35, three times salary at 45 and five times salary at 55. "The idea is to give people a rule of thumb so they know whether they're on track while they have time to make adjustments," says Jeanne Thompson, a Fidelity vice-president.
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Aon Hewitt, which provides bookkeeping services for 401(k) plans, sets a benchmark of 11 times final salary, and others use still other criteria. But the precise number isn't as important as the overall message. "These are all just calls to action to be an aggressive saver," says Utkus. "If you've only saved five times your salary and Fidelity or Vanguard says seven, you know to get on the stick."
If the quick-and-dirty formulas aren't precise enough for you, you'll have to do some fancy footwork. Arriving at a realistic figure to generate 70% to 85% of your preretirement income requires projecting how much your savings will earn before and during retirement, how old you'll be when you retire, the rate at which you'll withdraw your savings, and how much income you'll get from other resources, such as pensions and Social Security. If you're married, you need to calculate joint income and expenses as well as post-retirement distribution strategies. "We're all making assumptions and guesses about the future," says Rob Reiskytl, partner for retirement consulting at Aon Hewitt.
One obvious unknown is how long you'll live and, therefore, how long your money will have to last.
Men who make it to 65 can expect to live to 82, on average, and 65-year-old women can expect to live until age 85, according to the Society of Actuaries. Health, education and family history play a role in your own life expectancy (to see how, use the calculator at www.livingto100.com), but no one can predict the date of your demise. Unless your health or family history indicates otherwise, set the age in the low-to-mid nineties or even higher, advises Michael Kitces, a partner at Pinnacle Advisory Group, a wealth-management firm in Columbia, Md.
For an easy but somewhat more precise approach to figuring your nest egg, Kitces suggests multiplying your estimated preretirement household living expenses by 25, after subtracting whatever amount you'd get from Social Security and pensions. This calculation assumes you'll withdraw 4% in the first year you retire and adjust that figure annually for inflation—an amount some planners consider low enough to keep you from running out of money even if you live to your mid nineties. For instance, if you plan to live on $5,000 a month ($60,000 a year) in retirement and anticipate $3,500 a month in Social Security benefits for yourself and your spouse (including spousal benefits), your net amount is $1,500 a month ($18,000 a year) and your rule-of-thumb savings would be $18,000 times 25, or $450,000.
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You can get an estimate of your Social Security benefits by using the calculator at www.ssa.gov. For a look at how the variables affect your retirement-savings goal, see the retirement calculator at Kiplinger.com. Get an idea of how much to save at www.choosetosave.org by using the Ballpark Estimate in the worksheet or the interactive version.
Reassess the numbers
Relying on broad savings benchmarks is fine for most of your working life, but "as you get closer to retirement, you need to have a plan that takes into account the unique characteristics of your finances," says Dan Keady, director of financial planning at TIAA-CREF. Five years out, he says, "look at what you're actually planning."
You might be surprised to find that you're in better shape than you thought. For instance, if you're on target to pay off your mortgage by the time you retire, you may not need 80% of your income to maintain your standard of living or, if you live in a high-cost area and plan to move to a cheaper one, "maybe a 60% replacement rate is fine," says Keady. Health, travel plans, housing arrangements and marital status all play a role in how your money holds up. Meanwhile, as you age, your expenses are likely to go down: A 2012 report by the Employee Benefit Research Institute shows that household expenditures fall 19% by age 75 compared with age 65, 34% by age 85, and 52% by age 95.
In any event, by the time you're 60 or older, you should have a handle on the savings and income you'll be working with, says Yanikoski. "You've been dealt all your cards. From now on, the issue is how you play them." You could decide to reduce housing expenses—say, by moving to a less expensive home. Now is also the time to consider whether it makes sense to invest some of your savings in an annuity for lifetime income. If your savings look skimpy, plan to work longer.
As for your standard of living, "we're trying to set guidelines that expect the same lifestyle," says Reiskytl. "But in reality, you may have to back off a bit." Cutting expenses doesn't necessarily mean you'll have to change your standard of living dramatically, he says. "When you talk to retirees and ask them how it's going, they typically say it's fine. Behind the scenes, they may be making adjustments to live within their means."