Part Four In Our Series On How To Manage Your 401(k)
Saving for retirement should be approached as an income replacement plan. When you retire, you trade receiving a paycheck for free time. The problem is you still have living expenses and no one plans for a retirement with less quality of life financially than they have now. To achieve a successful retirement you must plan to replace your income from a combination of Social Security, pensions (if you are one of the few who are eligible), and your savings which, if you are like most Americans, is your 401(k).
A word about inflation
Inflation is a rise in the general level of goods and services over a period of time. Inflation is real and unless you include it in your planning it can wreck your retirement. Basically, everything that you will need to buy when you are retired will cost more than that it does now. If your electric bill now is $200 per month and inflation is 3% (the long term rate of inflation in the U.S. has been 3.2% over the past 100 years) then in ten years it will be $268! You must include inflation in your retirement planning if you wish to have enough money to have a comfortable retirement.
The process to determine how much to contribute to your 401(k) is summarized below (assuming you are currently financially comfortable):
1. Start with your current annual earnings
2. Calculate what your earnings will be just before retirement accounting for inflation
3. Subtract the amount you currently contribute annually to your 401(k) (You will not have this expense in retirement)
4. Subtract the annual amount you pay on debts that will no longer exist when you retire (mortgage, auto loans)
5. Subtract the estimate of your annual social security benefit (You can obtain this online at http://www.ssa.gov/myaccount/ )
6. Subtract the annual amount of any pension payments you are eligible to receive
7. The result is the amount of your annual earnings that will have to be replaced by the accumulated savings in your 401(k).
8. Determine how long your savings will have to deliver this income
9. Estimate your tax rate in retirement and adjust the required income accordingly
10. Use an online calculator or financial calculator with a present value (PV) function to calculate the total amount you will have to accumulate to deliver the desired amount of income
11. Choose a reasonable and realistic rate of return for your 401(k) savings
12. Use an online calculator on a financial calculator with a present value (PV) function to calculate how much you have to save to reach that goal
As an example, let’s work through the process for Joe Everyworker. Mr. Everyworker is 45 years old; his full Social Security benefit begins at age 67, so he has 22 years to retirement.
1. Joe’s annual gross earnings are $50,000 before taxes and deductions*.
2. At 3% inflation over 22 years to retirement, Joe will be earning $95,805 just before he retires at age 67. You can calculate this by using the compound interest calculator on Bankrate.com** http://www.bankrate.com/calculators/savings/compound-interest-calculator-tool.aspx after clicking the link select “Compound Interest Calculator” from the calculator list. (Hint: enter your current gross salary in “Investment Amount”, the inflation rate in “Interest Rate”, and number of years to retirement in “Years”. Your Projected Earnings are shown in the “Yearly Total” entry in the answer panel. In Joe’s case, if his pay keeps pace with inflation he will be earning $95,808 just before he retires.
3. Joe currently contributes 3% of his salary ($1,500 annually) to his 401(k) plan which won’t be needed at retirement so we subtract 3% of what he will be earning at retirement (.03*$95,805 = $2,874).
4. Joe’s monthly mortgage payment is $1,000 per month. He has no other debt. The mortgage will be paid off five years before his retirement, so no payment is needed in retirement.
5. Joe went online to http://www.ssa.gov/myaccount/ to obtain his Social Security statement. His estimated benefit, in inflated dollars (available directly from Social Security) is $3,703 monthly or $44,436 annually.
6. Joe is not eligible for any private pension payments in retirement
7. The income that Joe will have to replace in retirement from savings is:
$95,808 (Annual income just prior to retirement)
- $2,874 (annual contribution to 401(k)
- $12,000 (Annual debt payments paid off before retirement)
- $44,436 (Estimated SS benefit)
= $36,495 required income per year from his savings
8. Joe will retire when he is age 67. Average life expectancy in the U.S. is currently 79 years. We usually run projections out to age 85 just to be conservative. So Joe’s 401(k) will have to deliver income for 18 years (85-67).
9. Joe estimates that with social security and withdrawals from his 401(K) he will have about $84,000 in taxable income in retirement putting him in the 25% federal tax bracket (Joe lives in Pennsylvania which does not tax either Social security or retirement plan withdrawals (check your states tax laws). Since we used Joe’s gross income as a starting figure there is no need to adjust required income for Taxes.
10. Now Joe must determine how much he needs to accumulate in his 401(k). Joe knows that after he retires he will have a more conservative outlook and will have to adopt a more conservative portfolio consisting of 80% fixed income and 20% stocks. At historical rates of return the portfolio should generate 5% annually. Joe plans essentially to exhaust the portfolio by the time he dies. So to sum up… Joe’s 401(k) portfolio will have to supply $36,495 initially, plus 3% more each year (to adjust for inflation) for 18 years and at the end Joe plans to have exhausted these funds. All the while the funds would have been earning 5% after he retires. This is an annuity calculation and you can get your answer at http://www.numericalexample.com/index.php?view=article&id=57 . (Hint: Leave “Present Value” blank, enter the interest rate in “Interest Rate”, enter income required per year in “Initial Term Amount” and use” year” for time period,” Number of Terms” is the number of years the money has to last, and the “Indexation Terms” is the inflation rate required (3%). The result is Joe’s “Number” or the balance he will have to reach in his 401(k) account to deliver enough income to enjoy retirement at his current lifestyle. The result for our example is $533,928.
11. The question now becomes “How much does Joe need to save to achieve his “Number”? The answer again is an annuity problem and we can use http://www.bankrate.com/calculators/savings/saving-goals-calculator.aspx (Hint enter your current 401(k) balance in the “How Much Can You Spare for Your First Deposit” and use monthly compounding). Joe is comfortable with an asset allocation of 60% Stocks and 40% Fixed income which has historically produced a return of about 6.5% (more on this is our next post). Joe has a current 401(k) balance of $60,000. From this we learn that Joe has to save $486 per month or 12% of his gross earnings towards his retirement. In general we find a good rule of thumb is that savings of 10% to 15% of your gross earnings is required to fund an adequate retirement. This savings rate must be consistent from when you first start working until retirement and must not be touched until retirement.
12. If Joe has an employer match he can reduce his saving somewhat. Assume that Joe’s employer will match 100% of Joe’s contribution up to 3% of his salary. Joe needs to save 12% of his gross earnings. Joe can reduce his contribution to 9% (or $375 per month) his employers 3% will bring his total savings to 12% of gross and allow him to still meet his goal. Note that employer matches are at the discretion of the employer and the formulas vary a great deal from employer to employer. Also, if you change jobs a lot you may not have the full benefit of matched funds. Most employer matches are subject to a vesting table (you have to be at the company for a specified period of time to be able to take all of the match funds with you when you leave).
* We use Gross earnings in order to simplify calculations. Since retirement planning is an income replacement exercise and U.S. Federal tax brackets are so broad, most workers will be in the same federal tax bracket when they retire as when they were working. This may be an oversimplification for high income individuals (>$250,000 annually). These individuals should seek professional tax and financial planning expertise for retirement planning. Note that we highly recommend that all individuals seek competent, professional tax and financial planning help when planning for retirement.
** In general we recommend the financial planning calculators on Bankrate.com because they don’t ask for personal data to give you an answer and they don’t try and sell you anything other than the usual ads.
Thanks to Matt Staub and Jennifer Masters for their kindness in reviewing this post and their helpful suggestions and editing.