How much do I need to retire on?

Part 3 of a 3-part series

The previous two articles discussed how to figure your retirement income gap. The widely-accepted methodology applied was this:

(1) Estimate retirement income needs;

(2) Estimate retirement income resources;

(3) Subtract (2) from (1) to determine your Retirement Income Gap (RIG); and

(4) Estimate savings necessary to bridge the RIG.

As an example we assumed $72,000 of annual current expenses. It was estimated that only 70 percent of that amount, or $50,400, was required at retirement. If inflation runs at 3 percent prior to retirement in 10 years, the annual income required in the first year of retirement inflates to $67,733. Assuming a 6 percent earnings rate, liquidation of principal, a retirement period of 20 years, and post-retirement of inflation of 3 percent, the total capital needed to fund the retirement income need is $1,045,480.

Continuing the example, we assumed retirement income resources of $50,000 in a 401(k) plan and $40,000 in mutual funds. Ignoring future contributions and assuming a hypothetical 6 percent after-tax return, these resources grow to $161,176 in 10 years (this would be reduced by income tax on the portion of the $50,000 in the 401(k)) plan that was not previously taxed).

When estimated Social Security benefits of $14,000 and annual pension benefits of $9,600 are capitalized at 6 percent, the result is $270,690. Total retirement resources amount to $431,866.

The RIG is the difference of between retirement income needs and retirement income resources, or $613,614 in this example.

Bridging the gap

The starting place for bridging the RIG is to calculate the level annual savings you have to sock away to make up the gap. Assuming 10 years until retirement and a 6 percent after-tax earnings rate, the level amount required is $46,554. Calculating this amount with a financial calculator or a compound interest rate table is a piece of cake.

Some of this amount could be contributed to an IRA or an employer-sponsored 401(k) plan. Some of it could be squirreled away in private savings.

What if the amount of level annual savings needed is more than you think you can handle? How can you lower your savings amount and still achieve your retirement income goal?

One way is to start with a lower savings amount, but increase it annually by the amount you expect your salary to increase.

For example, say you expected annual salary increases of 4 percent between now and retirement. Assuming the same 6 percent after-tax earnings rate, you would need to save only $37,163 in the first year.

Another way to decrease the amount of required savings is to accept greater financial risk so that your expected return is higher. Keep in mind that accepting greater risk doesn't guarantee a higher return, it merely provides the potential for higher return.

But, if you restructured your portfolio so that a hypothetical 10 percent return were expected, the level amount required to fund the RIG decreases to $38,501. If you increased your savings amount by 4 percent each year and assumed an earnings rue of 10 percent, you would need to put away only $29,945 in the first year.

Another approach to decreasing the amount of retired savings is to push back your retirement date. Pushing back the retirement date not only gives you more time to save, it decreases the number of years spent in retirement and theoretically reduces the RIG.

For example, even assuming the retirement period remains at 20 years and the RIG remains the same, if retirement is pushed back five years so that you have 15 years to accumulate, the level savings required with 10 percent earnings rate drops to only $19,313. With increasing savings increasing at 4 percent, a 10 percent earnings rate, and a 15-year accumulation period, you'll only need to save $15,493 in the first year to close that $613,614 retirement income gap.

So, how much do you need to retire on? The answer depends on a variety of factors. So does the calculation of how much you need to save each year to bridge the retirement income gap.

Although this article and the preceding articles in this series provide a methodology and guidelines for determining where you stand for retirement, arriving at an answer is a challenging task.

Many people find the task challenging enough to require the assistance of a licensed financial professional who can provide them with several scenarios and specific recommendations for saving and investing.

Whatever route you choose to go, one thing is for certain -- time is money. The sooner you start preparing for retirement, the better off you'll be.

Sharon Stanley is a representative of The Prudential Insurance Co. of America in Cape Girardeau. (344-2603)