Thursday, September 11, 2008

Be Your own financial planner part 4 - Plan for your retirement

Planning for your retirement will likely be the single biggest financial goal in your life.  Ideally you will be saving for decades and living off the money for decades more.  There are no loans, scholarships, or shortcuts for retirement savings.  Either you save enough to live the lifestyle you want or you don't.

How much should you save for retirement?  That is up to you and depends on when you want to retire, what kind of life you want to live in retirement, and how much you have already saved.  At a bare minimum, I believe that you should be contributing enough to your 401(k) to max out any employer match available.  You should also be contributing to an IRA.

However, you don't want to just follow rules of thumb, you want to make a personal financial plan.

In order to save enough for your retirement you need to estimate what level of income you will need for retirement.  This is one of the reasons why it is important to understand how much income you are living on right now.  Take a few minutes to relax and picture what you want your retirement to be.  Where will you live?  Will you continue to work at all?  Will you want to travel?  What will you do with your time?

Some people believe that 70% of your current income level is a good estimate for what you will need in retirement.  I think that for the sake of estimating your total needs, it is better to start at 100% and work down (or up!).  Personally, I find that when I have more free time, I spend more money - not less.  However, I think that there are a few parts of my budget that I will be able to cut or eliminate once I am retired.

How do you think your financial needs will change in retirement?  For starters, you will no longer need to save for retirement.  If you have been saving 10% of your income, then perhaps you can live on only 90%.  If you are no longer working, will your clothing, dry cleaning, or transportation expenses change?  Will your house be paid off?  Will your house need repairs or remodeling? Will you be taking up new hobbies or devoting more time to your existing hobbies?  How much will that cost?

Once you have your estimate, it's time to plug in your numbers to see what you will need to save to meet your goal.  Yahoo Finance has a great calculator to help you figure this out.  Click on the link, plug in the numbers for your situation and see what you need to save.  If you don't know what to use for any of the variables, (such as inflation or investment returns) its okay to leave them at their set defaults.  Even if you are solidly committed to retiring at a certain age or with a certain level of income, I would encourage you to spend a few minutes trying out different scenarios to see how it effects your savings needs.

When you are done with this you should know how much money you need to be saving every month to prepare for your retirement.  Are you already at your goal?  If so, congratulations!  If not, then do what you can to meet your goal right now.  If you can't hit your savings target right away, don't panic.  However, keep working up towards it.  Until you are on track to fund your retirement, whenever you get a raise at least half of your new money (and preferably all of it) should be put aside for retirement savings or debt reduction.  The longer it takes you to increase your savings rate, the higher your savings rate will need to go.  If you are not saving enough, time is not on your side.

Now you have completed step five in your financial plan: figure out how much to save for retirement and start saving that much.

2 comments:

Anonymous said...

What would you consider a reasonable estimate for pre-retirement investment return? I have been using 8% for my retirement planning. I am contributing to my 403b plan at work with a diversified portfolio.

Thanks for all the advice!

RDS said...

Anon- Great question. The estimate that you use for your pre-retirement investment return has a big effect on the amount that you will need to save.

In general, I think that it is best to use historical averages. If you are investing in mutual funds inside your 403b you could use morningstar.com to look up the historical return of your funds. I would recommend using either the lifetime average (if it is 10 years or longer) or the 10 year average.

If you do not know the average returns for your particular funds, or if they are to new to have meaningful averages, you can use general returns. From 1926 - 1998 Government bonds averaged 3.7%, corporate bonds averaged of 5.7%, and the S&P 500, which is a good measure of the stock market averaged of 11.2%.

So, if your portfolio consists of 70% stocks and 30% government bonds you could calculate your expected return as:
70% of 11.2 = 7.84 (return from stock portion)
30% of 3.7 = 1.11 (return from bond portion)
Add these numbers together and you will get 8.95% as your total expected return.

RDS