How Do I Plan for Retirement? - Retirement Planning Advice

How Do I Plan for Retirement?

Retirement planning is not difficult. The goal is to make sure that you have an adequate income so that you can live the way you want even though you are no longer receiv- ing a paycheck.
To plan for retirement, then, you first need to figure out how much money you need to live on when you retire. A good starting point is what you already live on.

Obviously, you want to adjust your living expenses estimate for a mortgage that may be paid by the time you retire and for work expenses you may no longer have. Also, you need to adjust your living expenses for any hobby expenses, such as travel, that you don't have now because you are working, but will have after you retire. Finally, you should be prepared financially for the possibility of an increase in health-related expenses, especially those of a long-term nature, for yourself or for your partner.

After you determine what you need to live on when you are retired, you are ready to begin to figure out where that money is going to come from. Clearly, for anybody who has worked, national pension plans, such as Social Security, are an important factor.
In spite of the hand wringing and calls to arms concerning the Social Security
benefits that U.S. residents may or may not receive, we think you can count on Social Security as a source of retirement.

After you have identified how much money you need during retirement, and have some idea what you will receive from Social Security and any other pensions, you need to calculate how much money you have to save in order to amass an investment portfo- lio that will provide any additional income.

The safest way to make the first part of this calculation-the calculation of how much money you need at the start of retirement in order to provide dependable retirement income-is simply to divide the amount of annual investment income you need by an appropriate rate of return. For example-and just to make the calculations easy- suppose that you want to receive $50,000 of annual retirement income from your investment portfolio when you retire. Further suppose that you expect to be able to earn a rate of return equal to 5 percent during retirement. To calculate how much money
you need at the start of retirement in order to earn $50,000 of retirement income, divide $50,000 by 5 percent. The result is $1,000,000.226

An important variable here is the rate of return that you expect on retirement.
Particularly tricky is the fact that you need to deal with inflation that occurs over the years when you are retired. We recommend using a "real" rate of return, which is a rate of return that has been adjusted for inflation by subtracting the inflation rate from the rate of return. By using a real rate of return, you don't need to worry about inflation.

In effect, you subtract inflation from the rate of return and therefore from your future financial forecasts. Real rates of return should typically run 3 percent to 7 percent. You can, for example, buy bonds from the U.S. Treasury that will return a real rate of return equal to approximately 3 percent. In other words, the bond will pay whatever inflation is, plus 3 percent. Over time, the stock market has produced real returns of around 7 percent. We recommend that you use a 5 percent real return for calculations of your income during retirement.

After dividing your annual retirement income by the real rate of return-and thereby calculating how much you need to accumulate-you need to use a financial calculator to determine how much you have to save on a monthly basis in order to amass the retirement nest egg you need. Unfortunately, Money doesn't provide such a financial calculator in its features set. You can locate in several other places a financial calcula-
tor that will make this computation, however. If you have a copy of Microsoft Excel, for example, you can use Excel to make this calculation. If you have a handheld financial calculator, you can also use it. See the calculator's documentation for step-by-step instructions on how to do this.