11.2: Retirement Planning - Projecting Needs
- Page ID
- 112089
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Identify the factors necessary to estimate retirement savings.
- Estimate retirement expenses, length of retirement, and the amount saved at retirement.
- Calculate relationships between the annual savings required and the time to retirement.
Retirement planning involves the same steps as any other personal planning: determine where you'd like to be, and then figure out how to get there from your current position. More formally, the first step is to define your goals, even if they are no more specific than "I want to be able to afford a nice life after I stop getting a paycheck." But what is a "nice life," and how will you pay for it?
It may seem impossible or futile to project your retirement needs so far in advance, given the numerous uncertainties in life and the distance to retirement. But that shouldn't keep you from saving. You can try to save as much as possible for now, with the idea that your plans will become clearer as you approach retirement, so whatever money you have saved will give you a head start.
Chris and Sam were young urban professionals until they had children. Tired of pushing strollers through the subways, they bought a home in the suburbs. They are happy to provide a more idyllic lifestyle for their kids, but miss the "buzz" and convenience of their urban lifestyle. When their children are on their own and Chris and Sam are ready to retire, they would like to sell their home and move back into the city.
Chris and Sam plan to use the value of their house to finance a condo in the city. Still, they also recognize that real estate prices are often higher in more desirable urban areas and that living expenses may increase in the future. Now in their mid-thirties, Chris and Sam are planning to retire in thirty years.
Chris and Sam need to project how much money they will need to have saved by the time they wish to retire. To do that, they need to project both their future capital needs (to buy the condo) and their future living expenses in retirement. They also need to project how long they may live after retirement, or how many years' worth of living expenses they will need, so that they won't outlive their savings.
They know they have thirty years to save this money. They also know, as explained in Chapter 4, that time affects value. Thus, Chris and Sam need to project the rate of compounding for their savings, or the rate at which time will affect the value of their money.
To estimate required savings, in other words, you need to estimate the following:
- Expenses in retirement
- Duration of retirement
- Return on savings in retirement
If your retirement is years away, a lot can and will happen in the meantime. Estimating future needs may seem complicated, but you can start by using what you know about the present.
Estimating Annual Expenses
One approach is to assume that your current living expenses will remain about the same in the future. Given that over the long run, inflation affects the purchasing power of your income, you should factor in the effect inflation may have so that your purchasing power remains the same.
For example, if your living expenses are around $25,000 per year, you'd like to have that amount of purchasing power in retirement as well. Assuming your cost of living remains constant, if you are thirty years from retirement, how much will you be spending on comparable living expenses when you retire?
The overall average annual inflation rate in the United States is approximately 3.25 percent.[1] If $25,000 is the present value of your expenses, you need to calculate the future value, knowing your expenses will appreciate at a rate of 3.25 percent per year for thirty years. Using any online future value calculator, you can determine that your annual spending needs at retirement would be approximately $65,260.
In thirty years, you will need approximately two and a half times your current annual budget to maintain the lifestyle you currently enjoy. Fortunately, if you have savings, they won't be just "sitting there" during that time. They, too, will be compounding to meet your needs.
You can use your current expenses as a basis to project a lifestyle that is more or less expensive after retirement. You may anticipate expenses dropping with fewer household members and dependents, for example, when your children become independent adults. Alternatively, when you retire, you may wish to increase spending and live a more comfortable life, pursuing the things you've always wanted to do. In any case, your current level of spending can be a starting point for your estimates.
Estimating the Length of Retirement
How much you need to have saved to support your annual living expenses after retirement depends on how long those expenses continue or how long you live. In the United States, life expectancy after the age of 65 has increased significantly over the past century, primarily due to improved access to healthcare, medical advancements, and healthier lifestyles before reaching this milestone.[2] Table 11.2.1 shows the 2021 Period Life Table for Males and Females[3]. As shown below, females generally live longer than males. These additional years must be factored into retirement planning. Table 11.2.2 shows the 2021 Period Life Table for Females[3].
| Age | Expected Years Remaining |
|---|---|
| 65 | 16.95 |
| 70 | 13.69 |
| 75 | 10.62 |
| 80 | 7.92 |
| 85 | 5.65 |
| 90 | 3.90 |
| 95 | 2.76 |
| 100 | 2.09 |
| 105 | 1.58 |
| 110 | 1.16 |
| Age | Expected Years Remaining |
|---|---|
| 65 | 19.75 |
| 70 | 16.00 |
| 75 | 12.49 |
| 80 | 9.38 |
| 85 | 6.72 |
| 90 | 4.65 |
| 95 | 3.22 |
| 100 | 2.35 |
| 105 | 1.71 |
| 110 | 1.20 |
If life expectancy continues to increase at these rates, in thirty years, your life expectancy at age 65 could be almost another thirty years. In that case, your retirement savings will need to cover your living expenses until you reach age 95. At age 35, you may only have about thirty years to save enough to support yourself (and spouse or dependents) for an additional thirty years.
Estimating the Amount Needed at Retirement
You can use what you know about time and value from Chapter 4 to estimate the amount you would need to have saved up by the time you retire. Your annual expenses in retirement are a series of cash flows that will grow by the rate of inflation. At the same time, your savings will grow by your rate of return, even after you begin making withdrawals to cover your expenses.
Assume that when you retire, your retirement funds are invested to earn a 5 percent annual return. Also, assume the annual inflation rate is 3.25 percent, and your yearly expenses upon retirement are $65,260.
Table 11.2.3 shows what your situation would look like.
| Years after Retirement |
Annual Expense (3.25% Inflation Rate) |
Return on Savings 5.00% |
Return on Savings 2.00% |
|---|---|---|---|
| 0 | $ 65,260 | $ 65,260 | $ 65,260 |
| 5th Year | $ 76,587 | $ 60,008 | $ 69,367 |
| 10th Year | $ 89,868 | $ 55,171 | $ 73,723 |
| 15th Year | $ 105,453 | $ 50,725 | $ 78,353 |
| 20th Year | $ 123,740 | $ 46,636 | $ 83,273 |
| 25th Year | $ 145,198 | $ 42,877 | $ 88,503 |
| 30th Year | $ 170,377 | $ 39,421 | $ 94,060 |
| Sum (All Years) | $ 1,590,290 | $ 2,443,400 |
The amount you need at retirement varies with the expected rate of return on your savings. While you are retired, you will be drawing income from your savings, but your remaining savings will still earn a return. The more return your savings can earn while you are retired, the less you have to save by retirement. The less return your savings can earn in retirement, the more you need to have saved before retirement.
In Table 11.2.3 , the total amount needed at retirement is only about $1.5 million if your remaining savings will earn 5 percent while you are retired, but if that rate of return is only 2 percent, you would have to begin retirement with almost $2.5 million.
Let's assume your return on savings is 5 percent. If you want to have $1,590,290 in thirty years when you retire, you could deposit $367,957 today and let it compound for thirty years without making any withdrawals. But if you plan to make an annual investment in your retirement savings, how much would that have to be?
Estimating the Annual Savings for Retirement
In the example above, if you make regular annual deposits into your retirement account for the next thirty years, each deposit would have to be $23,936, assuming that your account will earn 5 percent for thirty years. If the rate of return for your savings is less, you would have to save more to have more at retirement. Your retirement account grows through your contributions and its own earnings. The more your account can earn before you retire, the less you will have to contribute to it. On the other hand, the more you can contribute to it, the less it has to earn.
The amount of time you have to save until retirement can make a significant difference to the amount you must save each year. The longer the time you have to save, the less you have to save each year to reach your goal. Table 11.2.4 shows this idea as applied to the example above, assuming a 5 percent return on savings and a goal of $1,590,290.
| Time to Retirement (in years) | Annual Savings Required | Funds at Retirement | Annual Return on Savings |
|---|---|---|---|
| 15 | $ 153,212 | $ 1,590,290 | 5.00% |
| 30 | $ 103,451 | $ 1,590,290 | 5.00% |
| 40 | $ 92,679 | $ 1,590,290 | 5.00% |
The longer the time you have to save or the sooner you start saving, the less you need to save each year. Chris and Sam are already in their 30's, so they figure they have thirty years to save for retirement. Had they started in their 20's and had forty years until retirement, they would not have to save so much each year. If they wait until they are around age 50, they will need to save significantly more each year to achieve their financial goals. The more you are required to save, the less disposable income you will have to spend on current living expenses, making it harder to save. Saving early and regularly is the superior strategy.
When making these calculations, be aware that you are using estimates to determine the amount of money you'll need at retirement. You use the expected inflation rate, based on its historic average, to estimate annual expenses; historical statistics on life expectancy to estimate the duration of your retirement; and an estimate of future savings returns. Estimates must be adjusted over time because things change. As you progress toward retirement, you'll want to reevaluate these numbers at least annually to be sure you are still saving enough.
- To estimate the required savings, you need to estimate
- expenses in retirement, based on lifestyle and adjusted for inflation
- duration of retirement, based on age at retirement and longevity
- return on savings in retirement
- You must save more for retirement if
- expenses are higher
- duration of retirement is longer
- return on savings in retirement is less
- Your annual savings for retirement also depend on the time until retirement; the longer you have to save, the less you need to save each year.
- Write in your personal finance journal your ideas and expectations for your retirement. At what age do you want to retire? Will you want to stop working at retirement? Where and how would you like to live? How do you think you would like to spend your time in retirement? How much have you saved toward retirement so far?
- Experiment with the retirement planning calculator available at Forbes.com (www.forbes.com/advisor/retirement/retirement-calculator/). What will you have saved for retirement by the time you retire? How much will you need to retire without income from employment? How old will you be when your retirement savings run out? Run several combinations of estimates to see how and why you should plan to save for retirement.
[1] McMahon, Tim. “Total U.S. Cumulative Inflation.” InflationData.com, August 10, 2022. www.inflationdata.com/articles/2022/08/10/u-s-cumulative-inflation-since-1913/
[2] Basaraba, Sharon. “A Guide to Longevity throughout History, from the Prehistoric Onward.” Verywell Health. November 22, 2024. www.verywellhealth.com/longevity-throughout-history-2224054
[3] Social Security Administration, Actuarial Life Table 2021. 2022. www.ssa.gov/oact/STATS/table4c6.html.