Monday, May 30, 2011

Overestimating Your Retirement Needs

A million dollars sounds like a nice round number to shot for when you discuss retirement planning. But the goal might be self-defeating for most folks as they check their quarterly balances in their 401(k) plans. In all likelihood, you contribute (but not enough) and your 401(k) plan is adequate (even a smallish 401(k) will have at least fifteen mutual funds, some of which will be passive type investments such as index funds). And even if you are average - average 401(k) balance of $20,000 and an average household income - around $50,000 - you can achieve enough wealth in retirement to do just fine.

And you can do it on a quarter of that sum, a much do-able number. But there are caveats, as there are in all things and not something you should ignore. First of which, we have briefly addressed is your expectations. Retirement savings, including Social Security is not really designed to replace 100% of your income. In fact, even in the heyday of the pension, and amongst those that still exist, the average payout is normally about 70% of what you can expect.

So working in round numbers: $50,000 in income/35 years until traditional retirement/10% contribution/4% return invested passively in index funds we have come up with the following future profile.

In retirement, you will need $35,000 a year in income. (Because of inflation, in 2046, that will be equivalent to $98,485. Inflation has the net effect of making what seems like a small amount look far larger. The flip side of inflation is that money will buy the goods at an equally inflated cost.)

Part of that income will come from your Social Security and/or pensions. To produce the rest, you should build up your nest egg (including your 401k, IRA and other savings accounts) to $251,110 by the time you retire. (In 2046, that will be equivalent to $706,590).

To save $251,110, your investments need to gain an average of 4.28% from now until retirement. If we are calculating this right, it is a safe estimate (about 99.78% chance) of this happening. But not without some effort on your part.

Even beginning at 30 can be considered young or starting early. With all of the rhetoric surrounding our longevity, the normal target age of 65 can be expected to be pushed back making 30 the new 20.

By passively investing, you have assumed as much risk as is considered advisable and even under the most modest of circumstances projected at 4% or slightly higher, the low cost of this type of investing will give you bigger gains than if you had assumed more risk at a higher expense.

And although inflation will inflate your net total, taxes based on the $35,000 a year income should remain relatively stable. And by using index funds across several markets (an S&P 500, a mid-cap and a small-cap domestic equity, an international index and a bond index) you have chosen the most tax efficient method of investing ever invented.

The remainder of the plan relies on you contributing 10% of your pre-tax income and staying out of debt. This means you will have to adhere to some sort of budget from now until the end.

The bottom line: a million might be too lofty a target for most and may spur some folks on to achieve more. But for the vast majority of us, comfort and security is enough to give us hope. More than that - strongly encouraged by the way - will simply be icing on the retirement cake.

Paul Petillo is the managing editor for and a fellow Boomer

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