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.
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