Retirement Planning for Beginners: Part Two

This week Money Mondays is going to last for three days:  Retirement Planning for Beginners in three steps.  I'm pleased to publish a guest post series by reader and frequent comment contributor, D. G. Pratt.  DGP (as he is known in the comments section) retired over a decade ago at the age of 45, so his retirement strategy has been well tested, surviving not one but two nasty bear markets. Yesterday he covered the basics of creating a budget,today, how to figure out how much you'll need.

Step 2: How Much You'll Need

Now that you know what it takes to fund your lifestyle on an annual basis, how much of a nest egg do you need to provide the income you need?  Let’s start with possible income sources.  Do you expect to have a pension?  (Most people will not have one.)  Are you eligible for Social Security?  If so, you will have received a form that estimates your benefit when you retire and when you can claim it.  (Editor's note:  The Social Security Administration has suspended sending paper estimates due to budget issues, but you can obtain an estimate on-line.)  [You will also be eligible for Medicare, such as it is, but will need to budget for medigap insurance and other items not covered.]  Social Security (and pensions, if any) will provide part of your income, the rest will have to come from your savings and investments.  Subtract the estimated Social Security annual total from your annual budget.  The remainder will be how much you will need to fund on your own.

Now you need to figure out how much of a nest egg will generate that income.  I prefer to use a moderately conservative “real return” of 4% in such estimates.  [Important: “real” return means the amount you earn after adjusting for inflation.  This is why your estimated budget and all other calculations can be done in today’s dollars; your investments will likely keep up with inflation and earn more than 4%.  You are solely concerned with the return over the rate of inflation.]  Some people will get even more aggressive and assume a real return of 5% or even 6% (this is nuts, in my opinion).  Others, to be on the safe side, might use a figure of 3%.  This return is generated by the investments, usually a mix of stocks, bonds, and cash equivalents such as money market funds and CDs.  It assumes that the total portfolio generates 4% above inflation over the long term.  Your actual investment performance will fluctuate over time with the vagaries of the stock market and interest rates but, over time, you ought to be able to make a 4% real return fairly easily and safely.   [How to do this is a subject for another day.]

At 4%, you will need a nest egg 25 times the size of the amount of the budget you need to fund.  [100 divided by 4% equals 25.]  So, let’s assume that your budget, less Social Security, is $20,000 per year.  To generate that income you will need a nest egg of $500,000 [$20,000 X 25 = $500,000].  This number is exclusive of the value of your house; since you will be living in it, the house will not (likely) be generating any income.  However, if you choose to sell your current house and buy a less expensive one elsewhere, the equity you pull out of the transaction, if any, is part of your investment nest egg.  This is a very common strategy used by retirees to generate a portion of their nest egg.

So, multiply the income you will need by 25 and that is the target you need for your nest egg.  If you choose to use an aggressive 5% real return multiply the income you need by 20.  If you choose to use a conservative 3% multiply the income you need by 33.  Yes, it really is that simple.

But, what if you want to retire early, that is before you reach Social Security age?

That and figuring out if you are on track tomorrow in Part Three.

Related Posts:

    Planning for Retirement:  Part One (Budget)

    How Much Money Do You Need To Retire?

    How Much Money Will You Need To Retire?

This is a post from Retirement:  A Full-Time Job.  Subscribe:  it's free (plus it makes me feel good.)

    

Comments

[Alan Spector]

Sydney, Maybe Retirement Planning for Beginners--Part 4 should simply read, "Read Your Retirement Quest; 10 Secrets for Creating and Living a Fulfilling Retirement." And in the spirit of full disclosure--this is from Alan Spector, Co-Author.

[dgpcolorado]

@Alan Spector,

My purpose in writing the two page essay some years ago was to distill the retirement planning process down to a simple form that would be accessible to my friends and that they would actually read. While I love reading financial planning books, most working people I know are too busy or too intimidated by them to do so.

The idea was to "keep it simple" and demystify the process.

-D. G. Pratt

[The-military-guide]

DGP, thanks for posting this. It gives people the confidence to get started, and sometimes that takes nudges from two or three different resources. Your series is going on my blogroll (thanks again, Syd!).

A retirement can't get started without your tutorial, yet I think that retirement is more complex than "just" financial security. Too many retirees have focused on the financials to the exclusion of the rest of their new life. The most frequent question I get isn't "How much will I need?" It's "But... what do you DO all day?!?"

I'm a financial-planning geek, but I'm also enjoying "Retirement Quest". The books that got me to retirement are classics, but to most of the people now pursuing retirement those classics are just "old"... and Retirement Quest is refreshing the genre.

[Rick]

Syd, DGP, and Alan ... I've followed Syd, now read a bit from DGP, and have read Alan's book (I think Syd recommended it some time ago). All great stuff and much appreciated ....

[dgpcolorado]

@The-military-guide, I'm not surprised that you get the 'what will you do all day?' question. But my experience, and that of some others, has been that once I retired I kept so busy that I don't know how I ever had time to work! That might be as good an answer to the question as any.

A lot of it depends on the personality of the retiree. Self-starters, those with a myriad of interests, and those who interact well with others, will find keeping fulfilled and busy in retirement fairly easy, if they are financially self-sufficient. Those whose job was their life and who have few or no outside interests or hobbies will have more difficulty. In the end, each person has to mull over the problem for him or herself.

I've mentioned it before in comments on Syd's blog, but the problem I faced when retiring quite early was dealing with what I call the "guilt factor" of no longer being a productive member of society. The solution I came up with was to do volunteer work. I gave it a try while I was still working, found I liked the work and the people I worked with, and the problem was solved. Now, a dozen years after retiring, I do massive amounts of volunteer work of a range and variety that my friends and family find remarkable. It keeps me active, productive, fulfilled, and allowed me to build a social circle in my adopted retirement community in an isolated rural area. And I still have plenty of time for engaging in hobbies and recreation.

If work is the only thing keeping one going forward, then perhaps full retirement isn't a good option. It isn't unusual for retirees to return to work part time to keep a bit of the old routine and structure in their lives. In a sense, my volunteer work is like that except that I don't get paid, and don't want to get paid because that increases the pressure and would take most of the fun out of it. For me. YMMV.

[Nance]

This is very good, but I would like help locating a 4% return.

With Treasuries at .23% (tops), CD's at 1.95% tops for two years, and most mutual funds, including indexed funds, in negative territory, and my broker's calling me up to ask, "Ain't you glad you're hiding out in cash right now?," I'd be grateful to locate a 4% return. Gold's dived. Oil's dived. If China goes wobbly as the wonks predict, kiss the infrastructure stocks good-bye, too.

I'm fully retired three years (Dec 31st, '07)... with a sterling, presumably water-tight retirement plan (backed up by state and federal pensions that quail in anticipation of a failure by the Super Committee in December) that asked only 4%, with every reason to believe the principle would go to my kids as inheritance. Right into the teeth of the You Know What that nobody anticipated.

Show me that 4%.

[Retired Syd]

Nance: Well it certainly is hard to believe we will ever be back to the glory days of federally insured CD's paying over 4% these days, isn't it? But the future is hard to predict--which is why I still believe you've got to hold all those things in a well-diversified portfolio. Just to remind you, the S&P 500 did return 25% in 2009 and 13% last year--not that that makes us feel any better after a nearly 37% drop in 2008, and then the losses we're experiencing this year. But those kinds of swings are typical of the market. Just looking back to the 70's, 1973 and '74 lost 14 and 26%--those folks were probably feeing pretty gloomy at that point too. But over the years, a well-diversified portfolio including stocks and bonds have returned over 4%--not necessarily for any 2 or even 5 year period, though.

The key is to have several years of cash available to wait out these periods, and to continue to rebalance (shifting some bonds to stocks when your stock portfolio looks horrible, and selling those stock funds for bonds when things look terrific. Hard to do, but easier than reading a crystal ball.

Unfortunately, we won't know whether we achieved that 4% for this 20 or 30 year period until we get there, huh? But "don't confuse certainty with safety":

http://retiredsyd.typepad.com/retirement_a_fulltime_job/2011/08/how-to-lose-money-in-the-stock-market-dont-invest-in-it.html

[Financial planning for retirement]

There are many more decisions that you have to make that are essential when it comes to financial planning for retirement and should be considered seriously. Keep in mind that the objective of these decisions should be to ensure that your retirement is comfortable.