If you haven't read Parts 1 - 3 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!
This is going to be a relatively short post. Now that you've put together a budget and come up with an idea of how much you can save each month, it's time to compare that number with how much you need to be saving and see whether you need to make some lifestyle changes to reach your goal.
Priorities, priorities
As we talked about in part 1, there are a variety of things to save for later in life, such as a down payment for a house, vehicles, vacations, college funds for the kids, etc. All of those things are important, and you should absolutely plan ahead and save for them. But retirement is the most important thing for you to focus on when you think about saving money. Nothing else that you need to save for will cost you as much as retirement, and nothing else will put you at greater risk should you choose to ignore it. Because of our increasing lifespans, you could spend as much time in retirement as you do in the workforce. I know 65 seems a long way off to you right now, but if you live to be 100 (and many of you will), you'll have thirty-five years left after you retire. Building a nest egg that can support you for that long is a difficult goal, and the sooner you get started, the better. Because of this, I recommend that you make retirement savings your top priority. I also recommend that you commit to saving as much as you reasonably can for the next few years. Getting those retirement account balances up early will pay off big time in the long run, as we saw in Part 1.
The New Retirement
Four or five decades ago, planning for retirement wasn't something that most people needed to worry about. Many people went to work for the same company for their entire career, and at retirement, your company would provide a pension that would pay you a set benefit for the rest of your life. For a variety of reasons, those types of plans started dying in the 70s and 80s and have all but completely disappeared today. Today, the vast majority of companies expect their employees to plan for their own retirement and fund their own retirement accounts. Retirement is now your responsibility. Also, if you're counting on Social Security to be your security, you've probably got some disappointment coming up. It's out of the scope of this series, but for a variety of reasons, Social Security is in peril and will exhaust its surplus sometime between 2042 and 2052, or about the time many of the readers of this series will be retiring. There are options to fix the problem, and it probably will be "fixed" eventually, but your benefits may be reduced or eliminated as part of the solution. The bottom line is that you can't count on the government to take care of you in retirement. You have to take of you in retirement.
What lifestyle do you want at retirement?
This is a good time to take a few minutes and think about your retirement and what you want it to look like. Do you want to buy a rustic cabin in a rural area and lead a simple life? Do you want to sell it all, buy a boat, and sail the world? Do you want to live in a high-rise condo in a major metropolis? If you have no idea of what you want, don't despair. You've got plenty of time to figure it out. Ultimately, your retirement income will be provided by your investments, and that income will determine the type of lifestyle you can afford in retirement. The more you save now, the more options you'll have later.
A million ain't what it used to be
Having a million dollars in the bank sounds like a fortune, and it is for some, but a cool million isn't what it used to be, thanks to inflation. In fact, you'd need about $20 million today to buy what $1 million would have bought you in 1907. And in another 100 years, inflation will likely erode the value of your money so that you'd need $369 million to match the $1 million from 1907. The causes for inflation are beyond the scope of this post, but the essential point is that inflation erodes the value of money over time. When you watch old black & white TV shows and they talk about buying a hamburger for a nickel or a ticket to the movies for fifty cents, you're seeing inflation at work. Over time, inflation causes the price of goods and services to increase. Inflation has averaged around 3% for most of the last century, so 3% is usually a fairly standard estimate of future inflation. What this means for you is that making $100,000 / year might sound great now, but inflation will likely make that sound not nearly as good in the future. If it stays at 3% for the next 40 years, $100,000 / year will be the equivalent of making a little over $30,000 in today's dollars. The bottom line is that you'll need to adjust your desired retirement income for inflation, but we'll cover that in more detail in a bit.
How much will you need at retirement?
It's difficult to know how much retirement income you'll need in four decades, but a good rule of thumb is to use 75 to 85% of your pre-retirement income. So, if you make $100,000 the year before you retire, you'll want to plan for $75,000 to $85,000 per year once you've retired.
To determine a rough idea of the total amount you'll need in retirement, take the amount you plan on spending in the first year of retirement and multiply by 25. In the example above, you might take $80,000 and multiply by 25 to come up with $2 million. This is roughly what you would need in your combined retirement accounts when you retire. This does not take income from Social Security or other pension-type benefits into account.
How much should you save?
Once we've determined roughly how much income we need in retirement and roughly what our goal is for our retirement account balances, we can determine how much we should be saving now. There are a couple ways to do this:
Go by the 15% rule
This varies depending on who you talk to and what your goals are, but many financial advisers recommend saving 15% of your income for retirement, including any matching that your employer may offer (we'll cover employer matching in a later post). If you're having a hard time deciding what kind of retirement you want to have, are not sure how your income is going to increase over the course of your career, etc, then the 15% rule may be just the thing for you for now. Saving 15% of your income while you're young may be difficult, but will put you in an excellent position later on.
Use a retirement calculator
If you're a little more numbers-oriented, you may want to use a retirement calculator to determine how much you should be saving. I recommend one from Bloomberg.com, located here. I'm sure there are other good ones out there, so please leave suggestions in the comments.
Task: calculate retirement savings targets
You need to calculate 3 things:
I highly recommend that you use the financial calculator from Bloomberg.com. I recommend starting with the default values, changing only your age, income, current level of retirement savings, and current contribution amount. The calculator will then tell you whether you're saving enough. If you need to save more, try gradually increasing the contribution percentage. The calculator will estimate what amount you'll make the year before you retire, how much your investments will pay you in retirement, and when the money will run out, if ever. This should give you a good sense of how you're doing and what you may need to change in order to reach your goals.
Don't forget to check back Wednesday for Part 5!
Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.