Retirement Nest Egg

By: Gary Foreman

Dear Gary,

Can you share a guideline for calculating how much money someone should save for retirement? Thanks! Stephanie K.

Stephanie is wise to begin planning for retirement. Too many of us watch the years go by and hope that Social Security will take care of it. But, that's dangerous thinking.

In Congressional testimony, the chairman of the Fedral Reserve Board, Allen Greenspan had this to say. "The dramatic increase in the ratio of retirees to workers that seems inevitable, as the baby boom generation moves to retirement and enjoys ever greater longevity, makes our current pay-as-you-go social security system unsustainable." That means that we need to prepare for our own retirement.

How much do we need to save? No one can predict the future. So we'll need to analyze the situation and apply some history to estimate an answer for Stephanie.

There are really three questions to answer. How much income will she want each year? How much capital will it take to earn that much income? How can she adjust for inflation?

Let's begin with the first question. How much income will she need when she retires? Traditionally it was thought that most people would see their expenses reduced after they retired. So they'd only require 75% of their pre-retirement income. The idea was that retirees spend more time at home. No need to buy clothes for work. No more commuting and lunches out. So if Stephanie is spending $50,000 per year now, she'd need about $37,500 per year at retirement.

But, many are rethinking the old rules. They point out that new retirees are full of energy. Many have been waiting for their retirement years to take up hobbies or travel. Those activities cost money. So it's not uncommon for financial planners to tell clients to expect to spend just as much after retirement as they did before.

What should Stephanie do? Shoot for her current income. No one ever complains about having too much income.

Next question: How much money will it take to produce the income that Stephanie needs? That will depend on how much she expects her savings to earn each year.

History will give us an idea of how much income her retirement fund should generate. Over the long term stocks have averaged a little better than 10% per year. Bond investments have earned a bit over 5% per year. There's no guarantee that history will repeat itself. But, over most ten year periods the returns have been remarkably close to those averages.

So let's say that Stephanie will earn 7% on her savings in retirement and wants to have $50,000 a year in income. To calculate how big her retirement fund must be divide the annual income desired by the investment return. In this case that works out to $714,285 ($50,000 divided by 7% or 0.07).

To picture it another way, your principal will earn a certain amount each year. Multiply your nest egg by the earnings rate to get the annual income. Or $714,285 x 7% = $50,000.

Still with us? OK, there's one final step to take. And that's to consider the effects of inflation. As prices go up, Stephanie's nest egg buys less.

How much inflation should she expect? If you look at historical prices provided by the Federal Reserve Board, you'll find that there's no one average for inflation. We've had periods where prices went down and some when they went up a lot. Lately inflation of 2 or 3% has been the norm.

Stephanie will need to make a guess about future inflation rates and then adjust periodically as she gets nearer to retirement. Let's use 3% since it's close to the recent level.

She can calculate the effects of inflation a couple of different ways. One is to buy a financial function calculator. They cost about $15 and are easy to use. A second way is to do it manually. If she expected 3% inflation she'd multiply $714,285 by 1.03. And then multiply the answer by 1.03 again. And again. Once for every year until she retires. If she's 34 now, she'd repeat the calculation 31 times. In case you want to try it, the answer is a little over $1,785,000.

So how does Stephanie save this huge pile of money? No, it's not impossible. The total will be made up of any company pensions she's earned, her 401k accounts, IRA's and other savings that she's set aside for retirement.

In rough terms, she'll need to be about half way to her goal by age 55. When she's 45 she needs to be 1/4 of the way to her goal. At age 35 she needs to be about 1/8 of the way to her goal.

How much is that per year? If she starts at age 24, she'll need to save about $8,000 per year. However, if she waits until age 34, she'll need to add about $17,000 to the various retirement accounts each year.

The assumptions she uses will make a big difference, too. We assumed 3% inflation and a 7% investment return. If the investment return were 10% she'd need annual savings of $9,500 (age 34) or $3,600 (age 24).

The most important thing is to not be frightened by the amount needed. Rather, remember that the sooner you start the easier it is. And it's better to save something even if it's less than your goal.

Thanks to Stephanie for asking a good question. Hopefully, it will spur more of us to begin saving for that post-retirement vacation.

Gary Foreman is a former Certified Financial Planner who currently edits The Dollar Stretcher website You'll find thousands of free articles to help you save time and money. Visit Today!

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