How much do I need to retire on?

Part 1 of a 3-part article

With retirement looming just around the corner for a large segment of the population, and with the nightly news full of cautions about how few people will have enough set aide, a question increasingly cropping up at dinner parties is: "How much do I need to retire on?"

Although the answer depends largely on how well you want to live in retirement, how long you live, and how healthy you are while you're alive, you can use a widely accepted methodology among financial professionals to get a ballpark idea of where you stand. You can also figure out how much you need to set aside monthly to make up any shortfalls.

The methodology boils down to this:

1. Estimate retirement income needs

2. Estimate retirement income resources

3. Subtract (2) from (1) to determine your retirement income gap (RIG)

4. Estimate savings necessary to bridge the RIG

Your RIG isn't exactly how much you need to retire on. Instead, it's something even more meaningful -- it's how much more you need to retire on.

Retirement income needs

A straightforward approach to estimating retirement income needs is to add up your current annual living expenses and assume that you'll only need 60 to 80 percent of that amount to retire on. Include major items such as housing, transportation, income and employment taxes, education and insurance. But, don't forget smaller items like food, clothing and entertainment.

Why only 60 to 80 percent of current living expenses? The theory is that the mortgage will be paid off, children will be educated, and employment taxes will be reduced to zero. Also, it's expected that you'll be less mobile and care less about fancy clothes and finely coifed hair.

But, there's another theory that says your expenses could stay the same or even increase if you plan to travel and/or you require expensive medical care. You'll have to decide what is a reasonable for assumption for you.

Let's say your current expenses are $72,000 in today's dollars. Seventy percent of this is $50,400. Despite the relatively low inflation of recent years, there is no guarantee inflation will stay in check and you'll probably want to assume that inflation increases your retirement needs. Historically, inflation has averaged between 3 to 5 percent annually and many financial professionals recommend an assumption within this range. Using a compound interest table or financial calculator, it's a simple matter to project your retirement income needs in today's dollars to retirement age.

Assuming inflation of 3 percent and 10 years until retirement, a $50,400 retirement income need today grows to $67,733 by retirement.

Next, you need to calculate the capital necessary to fund your retirement income need. One consideration is whether inflation continues post-retirement and, if so, at what rate. Another consideration is whether you intend to liquidate capital or "live off the interest." Yet another consideration is what after-tax rate you expect your investments to earn. A final consideration is how long you expect to live.

Again, it probably makes sense to assume post-retirement inflation at a modest rate. Many financial professionals encourage clients to preserve capital, but this requires a much larger retirement nest egg. The after-tax investment rate is a function of what you expect to happen to tax rates and how much investment risk you're willing to take-the assumption being that the greater the risk, the greater the potential return.

How long you expect to live depends on family history, lifestyle and health. If someone else is dependent on your resources, keep in mind that it's not just your life expectancy that must be considered, but that individual's as well.

In the next article, we'll determine retirement income resources and calculate the RIG.

Sharon Stanley is a representative of The Prudential Insurance Co. of America in Cape Girardeau. (334-2603)