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It's Retirement-ary, My Dear

I crawled out of bed this morning. Not literally, but my age is starting to catch up with me. My back is nagging, my eyes are sagging, my hair thinning... who knew 24 could be so brutal!

Unfortunately we can't stay young forever, dab-nabbit. So planning for our future is only logical when we're faced with the concerns of our time. Right now, a lot of us making salary find that inflation rates are a big cause for concern. Soaring prices of basic goods and services, a trend that doesn't seem to show a steady weakening over time, make it lousy to depend mainly on retirement benefits when it's time for me to hit the rocking chair. For now, I still have time to plan.

Financial advisers talk about identifying first the lifestyle that a person wants upon retirement and this should help me arrive at a ballpark figure of how much I should be able to withdraw every year from my nest egg. However, it seems like most advice for young people planning for retirement consists of "save as much as you can now, and figure out how much you'll actually need later." Your 20s is a great time to save and take advantage of the wonders of compounding interest-- and there are so many variables involved in predicting future retirement needs-- so this is quite good advice, if it satisfies you.

The problem is, it doesn't satisfy me! I really like having goals, targets, an idea of where I'm going and how well I'm doing. So as challenging as it seems, and even though it's probably an unnecessary step at my age, I still want to come up with "my number," even if it's one that gets revised many times in future years.

For starters, I want to try to estimate how much income I'll need in retirement. (All numbers will be in 2009 dollars for now, and we'll adjust for inflation later.) I see so many people talking about wanting six-figure retirement incomes: $100,000, $200,000, sometimes even more. When you run the numbers, the amount you need to save to produce those amounts seems astronomical and overwhelming. (Although doable for some people, I'm sure.)

But those don't feel right to me. One common suggestion to calculate your retirement expenses is 80% of current expenses. 80% of my current expenses (in my near debt free life) would come out to about $12,000 a year. Which sounds really, really low. Maybe my current style of living is way off from what I'd want in retirement; even though I bet I'll continue to be frugal, there are probably some inconveniences I'll no longer be willing or able to put up with to save a buck or two.

Then I found this data from a study of older Americans. It finds that the average expenses of a married person over 65 was $14,762 in 2001. Maybe I'm not so far off! And even for couples in the top 20% of income, average expenses (per person) was $25,567, spending about 1/4 of that on entertainment and gifts. (There's all sort of interesting data in the report to help you think about what you might end up spending.)

Based on these numbers, I think I'm going to go ahead and use $25,000 as my yearly expenses/income-needed number (in 2009 dollars; I promise I'll adjust for inflation later!). If it's (almost) enough for the average person in the top 20% of income, it ought to be more than enough to cover a frugal-minded little old lady like me. And it's more like 160% of my current expenses, rather than 80%. I feel like my expenses might actually end up lower in reality, but I might as well play it on the safe side in these estimates.

I'm guessing most people are making plans assuming you'll get nothing from Social Security. That's certainly the safest route. But on the other hand, I'm in my 20s. As I try to come up with this estimate of needs, I'd like to try to be as realistic as possible. If I turn out to be unnecessarily optimistic, I've got decades to course-correct. (And besides, I'm not planning to change anything about my savings at the moment-- so this estimate is just informational.)

Of course, at first I thought that "$0 (or very little) from Social Security" was the most realistic estimate. But reading up on it, it looks like Social Security isn't predicted to go broke until I'm 60 or 70-- and broke only means that the trust fund will be depleted and inflows would have to cover outflows, which means benefits would fall to about 75% of their promised levels. 75% isn't great, but it's way, way more than 0%. (And that's if no action's taken to improve the system so benefits don't need to be cut.)

The Social Security calculator projects my benefits would be the equivalent of $17,000 a year in today's dollars (after adjusting the earnings projections to make them more conservative). 3/4 of that is $12,750. Heck, even if benefits get cut in half, it'd be $8,500. That's certainly not enough alone for me to live on-- but it's not peanuts.

I'm estimating my annual retirement living expenses at $25,000. So a reasonable estimate (although obviously not fool-proof) is that Social Security would cover between 1/3 and 1/2 of those expenses. Not too shabby.

I'll use the 50%-of-promised-benefits estimate to be on the safe side, which suggests I'll need $16,500 a year (in today's dollars) from my investments. In the meantime: how do you handle Social Security in your planning, and why? I'm personally trying to come up with a reasonable, realistic estimate here, not the most ultra-safe one. But I guess you can't go wrong assuming you'll get nothing and being pleasantly surprised when/if you do (unless it leads you to make sacrifices in the present which on balance you'd rather not make).

So once you estimate what retirement income you'll need, how do you figure out the nest egg that will produce it? A tricky question for anyone, especially for those of us who are decades and decades away. But I'll give it a try anyway; be warned that this post contains a lot of details, numbers, and statistics!

For starters, who knows how much inflation will occur over the next decades? None of us, obviously. Inflation has varied widely over different periods in history. Some years it's been over 10%; some years it's been negative (deflation). Over the last 80 years as a whole, inflation has averaged about 3.1%, but in recent years it's been higher. Most retirement planning advice I've seen suggests assuming inflation rates anywhere between 2% and 6%, with 3% or 4% (or something in-between) being most common. So given how arbitrary this number is going to be anyway, I'm going to go with 3.5% as my inflation rate.

Great, what does that mean? Well, it means I can figure out what dollar amount I'll need when I start retirement (for me, I'm going to say it's 2053, when I'm 68). I've yet to find a good simple calculator to do this process (tell me if you know one!), but I do know a handy shortcut called the Rule of 72. Basically, if you divide the number 72 by your interest (or inflation) rate, the result is how many years it takes to double at that rate. For example, if you have $100 at 6% interest, in 12 years (72/6) you'll have $200.

So the question is, how many years does it take inflation to double the amount of money you need? I divide 72 by 3.5 to get a little less than 21 years (you can do the same if you want a different inflation assumption). So by 2047 inflation will have caused my income needs to quadruple (double twice), from $16,500 to $66,000. Three more years at 3.5% would bring it up to $73,000. So I need $73,000 in 2050 dollars to retire on.

And how do you get $73,000 a year (or whatever your amount is)? Well, it depends on whether you want to leave your nest egg intact and live only on the interest (the safest approach, and one that preserves your savings for your heirs), or are planning to use up the savings over time. For me, it's certainly not a priority to leave money behind for my kids-- especially if accumulating the wealth to do so affects my ability to make the family happy when I'm alive-- and as we've established, I'm trying to be realistic but not overcautious here.

So, most advice I've seen suggests that withdrawing somewhere between 4% and 5% of your portfolio in the first year of retirement, and adjusting for inflation thereafter, will likely keep your nest egg alive for 30 years. 3% is the ultra-conservative choice; some people do 6% or 7% or more, but that seems too risky. So I'll pick a 4.5% withdrawal rate. If I withdraw 4.5% in 2050 to get my $73,000, that would make my number $73,000 / .045, or (drumroll please...) $1,622,222.

Wow. I need almost two million dollars. Granted, that's in 2050 dollars, which is the equivalent of less than $500,000 today, but that's still a sizable hunk of change.

The good news? I'm 24 today, and I have decades to take advantage of compounding interest, so it's easier than it looks, and if you're near my age you're probably in the same boat.

For curiosity's sake, how much would I need in savings today to end up with the $1.6 million I've projected I need? Well, my money ought to double nearly 5 times, so by my math, I'd need a little more than $50,000.

$50,000. Doesn't that sound a lot more manageable than $1.6 million?

Of course, I don't have $50,000 now, and I won't have it anytime soon. I have about $1700. So how about another easy number-- 36 years out from retirement, enough time for my savings to double four times with 8% returns. For me, that's 2017, eight years from now, at age 32. If I end up with $100,000 by then, and my other assumptions hold up, I could theoretically leave my money to compound, never save another dollar for retirement, and still reach my goals. I'd have $100,000 in 2017, $200,000 in 2023, $400,000 in 2032, $800,000 in 2041, and $1,600,000 in 2050. (Isn't that exciting to watch?!)

(Important disclaimer: don't forget about taxes!)

I think I am going to try hard to reach that $100,000 goal by age 32. It's ambitious, like all good goals are, but also realistically acheivable. By that age I will have graduated with my Bachelors, maybe gone back for a Masters, be well into my career and thanks to the wealth of financial information I'm acquiring early on be more than equipped to meet that goal. Then everything I save for retirement after that time would be pure gravy (well, also insurance against all of the ways my assumptions could be wrong, but that's a given). I like that thought a lot.

You can come up with a similar goal. Just fiddle around with the Rule of 72 until you come up with a goal you think works for you. You could assume 8% returns like me, but set a goal of 1/8 of your retirement "number" to be reached 27 years ahead of retirement (instead of my 1/16, to be reached 36 years ahead of time). You could assume 9% returns, and set your short-term goal at 1/16 of your retirement goal, 32 years before your retirement date (doubling four times, once every 8 years). You could assume 7% returns (so your money doubles every 10.29 years) and look to reach 1/8 of your retirement goal 31 years before retirement. See how flexible it is?

So, there we are. I've estimated my annual retirement expenses in Part 1, thought through Social Security in Part 2, calculated my needed savings in Part 3, and now I've come up with a plan to reach that total with time to spare. I have a goal-- to save $100,000 for retirement by 2017-- and the confidence that if I do so I have a reasonable chance of reaching my retirement goals without significant additional savings after that point. I'm sure I will continue to save past 2017, but this goal also opens things up for me to imagine more flexible ways of working and living in my 30s, 40s, and 50s which focus on the present without worrying so much about the future. I've enjoyed this process, and I hope you have too.

And if you're still a bit uneasy or it is a lot for you to take in one sitting, Retirement for Dummies is offered as a free gift when you register with Humana.