Seeking Alpha
Profile| Send Message|
( followers)  

Everyone has a "number" -- that is, an amount of money that would allow them to stop working and live comfortably for the rest of their lives. However, a lot of investors either grossly misjudge this amount, or don't know how to determine their number at all. While there is no one-size-fits-all formula to determine this, there are some general guidelines to follow. A retirement investor can plan his/her goals based on his/her answers to the following questions:

  1. When do I want to retire?
  2. How much will I need to maintain my lifestyle in retirement?
  3. How much income will I have from other sources?
  4. How much do I expect my money to earn between now and my retirement?

Let's start with question 1. This is critically important, because the timeframe determines how much saving is necessary to meet a retirement goal. Let's say I want to retire at age 59, when I will (hopefully) qualify for the maximum pension from my employer. I always encourage people to set ambitious goals. People are often surprised how far a little bit of extra saving can go towards adding years to their retired lives.

The next question is a little more complicated, and the best advice is to try to make this number as low as possible while maintaining your lifestyle. For example, I have a personal goal of having my house paid off and having no outstanding debt on credit cards or other loans before I retire. Not having a mortgage to pay helps tremendously in lowering cost of living. Remember to account for healthcare costs, especially if there is to be a gap between retirement and medicare/social security age. Let's say, for example, that I want to have $75,000 per year, after taxes, in order to live comfortably in retirement. It is also VERY important to take note of inflation. In other words, $75,000 in 20 years will not be worth $75,000. For the purposes of this article, I will use the average historic U.S. inflation rate of 3.43%. Some years it will be more, some less, but this essentially means money will lose half its value every 20 years.

Since I want to retire in 28 years, this means I will need $186,470 annually in inflated dollars to provide me with the kind of lifestyle that $75,000 provides today. This sounds like a daunting amount, but read on. It is more easily attained than you think. The power of compound interest and reinvesting dividends works wonders over that long of a time period.

Next, figure out what other sources of income you have, such as a pension. Social security can be counted, but only if you don't plan on retiring until attaining social security age. (I know that social security is in trouble, but let's assume it will exist for at least the next 25-30 years -- more on this in a future article) For example, as an educator, I am part of the state retirement system, and my pension should be worth approximately $30,000 per year (in today's dollars -- with inflation adjustments, it should be around $74,500 ) after 30 years of work. This leaves around $111,470 as the income I will need from my assets.

I have discussed dividend investing and other strategies previously, and believe it is totally possible to achieve 7% pre-tax returns on a retirement account with very low risk, combined with growth that will meet or exceed historic inflation rates. You can achieve a higher or lower return, depending on your specific appetite for risk. If returns are taxed as either dividends or long-term capital gains, they would be subject to a 15% tax rate (or at 0% if you are in the 10% or 15% tax bracket). So, a 7% pre-tax return becomes a 5.95% post-tax return. At this rate, I would need $1,873,455 in my "future dollars" to safely generate the income I want.

In calculating my "number," I made a few assumptions. I assumed that my average annual return will be 11%, the historic average of the S&P 500 (NYSEARCA:SPY). Of course, I hope to do much better, but for the sake of this estimate, 11% is my target. I also assume that I start with a $30,000 portfolio, which is reasonable for the average investor who is 25-30 years from retirement. Finally, I assume that I will increase my own savings to match inflation each year. Here is what I came up with…

To meet my retirement goals, I would have to begin by saving $6,570 this year, or $574.50 per month. I would then have to boost this amount by the 3.43% average inflation rate each year until I retire. This is a small price to pay for a comfortable early retirement, and a surprisingly low amount, given my target end result of over $1.8 million. If you are having trouble figuring out what your number is, or how much you will need to save to get there, set up a spreadsheet similar to what I have above and play around with the numbers and your expected return (or send me a message, and I will gladly send you my spreadsheet). My "number" is $1,873,455. What's yours?

Source: How To Determine Your "Number" For A Comfortable Retirement