How To Estimate Your Retirement Income Needs

How much is enough?  That can be an overwhelming question for someone in their 50′s or 60′s and downright unfathomable for someone in their mid-twenties.  There are just too many “what-if’s” in our future.  A few obvious “what-if’s” include:

• When do I want to retire?
• When can I retire?
• How long will I live?
• How will my health affect how much I need?
• What about social security?
• What are my retirement goals? (travel, vacations, country club memberships etc.)

And this is only the tip of the iceberg.

Even though you will have a hard time answering these questions accurately, it does not mean that you can’t develop an adequate long-term retirement plan.  Here are two different ways the financial planning community might go about helping you estimate your expenses in retirement:

1. Replacement Ratio Method – method used to estimate after-tax retirement income needs in current dollars by multiplying current expenses by a factor of 70 to 80 percent.

For example: if our current estimated expenses are $55,000 per year and I assume that my expenses after retirement will be 80 percent of current expenses, the replacement ratio method will suggest that my retirement needs in today’s dollars are $55,000 X .8 = $44,000.00.

The problem with the Replacement Ratio Method is that I really can’t be sure that my yearly expenses in retirement will be less than they are today.  In addition, I haven’t found any hard statistics that actually prove retirees’ expenses are 70 to 80 percent less in retirement.  Nonetheless, it is a common way to get one started.

2.  Adjusted Expense Method – method used to estimate after-tax retirement income needs in current dollars by adjusting current expenses for changes expected in retirement.

This method is obviously more cumbersome to calculate.  But it is a more accurate measure than the replacement ratio method detailed above.  For example, you may be paying a mortgage now, but you may be expecting to be mortgage free by retirement.  You should adjust the mortgage amount expense accordingly.

So now what?  Either of these methods is a great way to estimate your future retirement expenses.  But of course, you may be thinking I forgot something, right?  After all, my blog is called “The Broke M.B.A.” and the thought has crossed your mind once or twice that I’m broke for a reason…. Ok, I’m assuming being broke has more to do with me not quite being out of school yet instead of a lack of intellect.  Nonetheless, we have yet to talk about one final concept, regardless of the method used: adjusting for inflation.

That’s right, each method above calculated our needs in today’s dollars. We’ll have to adjust this for inflation.  The time value of money concept illustrates why $44,000 today is not the same as $44,000 25 years from now.  To adjust your estimated retirement income needs for inflation, use this formula:

This formula indicates that when I retire in 35 years, $44,000 will be the equivalent of $173,627.91.  If this sounds like an incredible number, it’s because it is.  But don’t forget that your investments will also be taking advantage of compound interest and should hopefully out pace the 4% estimated inflation.

There is one final thing to consider.  Don’t forget to factor in the income taxes you will have to pay when you begin withrdrawing funds from your retirement accounts.  Who knows what the tax code will look like in 35 years, but it would be wise to keep this in mind. (In an effort to minimize your future retirment income taxes, you should consider taking advantage of vehicles that let your money grow tax-free such as the Roth IRA.)