Taking It One Step at a Time

It seems that everywhere you turn these days, somebody is telling you something horrible about your prospects in retirement. Expert after expert warns that Social Security won’t be around as long as you are, that your company pension may prove inadequate and that Americans aren’t saving enough to pick up the slack.

Nobody wants to be poor when they’re old. As a result, saving for retirement has become America’s No. 1 personal financial goal.

But how do you know how much to save? How can you tell when you’ve saved enough? How do you balance the incessant financial demands of everyday life with the need to handle a potentially gigantic long-term obligation?

It’s not as hard as it sounds. You just need to take it one step at a time.

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Step 1. Determine what you’ll need.

Before you can contemplate how much you need to save for retirement, you need to figure out how much you’ll spend in retirement. In other words, you have to compile an estimated retirement budget.

How do you do that? Start with your current budget and then hypothesize about how your financial life will differ in retirement. Subtract monthly expenses that you don’t expect to have at retirement and add back in those you don’t have now but probably will then.

What about inflation? That’s step two. For now, don’t worry about it. Do everything in current dollars. We’ll adjust for inflation later.

To get started, take your average monthly expenses and start subtracting work-related expenses, retirement savings contributions and other monthly costs that aren’t likely to last when you quit work.

For instance, a portion--possibly a large portion--of your clothing budget is work-related. So are some of your transportation expenses--such as parking, gasoline, bus or train fares. Chances are you won’t be eating lunch out as often during retirement, either. So subtract the portion of those costs that you can reasonably expect to go.

If part of your budget goes to 401(k), IRA or Keogh contributions, subtract that out. If you’re now paying private school expenses for your kids--and you expect them to graduate before you retire--deduct that cost from your monthly budget too. If you’ve got a home and expect the mortgage to be paid off, deduct the payment from the total.

Now start adding in expenses for things you want to buy--or expenses you think are going to be necessary--in your golden years.

For example, you may have grand vacation aspirations. If so, budget in an amount that would pay for that type of vacation today. If you’re young and healthy, you should also expect that your medical expenses will be at least somewhat higher in retirement than they are now. If you want to be golfing every day once the workaday world is behind you, start adding up the greens fees and the cost of a cart.

When you’re done, you should have a dollar figure that is a rough estimate of how much you’ll need each month to live on in retirement.

Record that number here:

$___________

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Step 2: Adjust for inflation.

Pull out your calculator. You now need to adjust the above figure for inflation. To do that, you’ll need to make a reasonable estimate of what inflation will average in the future. And you’ll have to consider how many years you’ll have until retirement.

Inflation has averaged 3.13% for the last 70 years, according to Ibbotson Associates, a Chicago-based economic research and consulting firm. It’s reasonable to assume it will continue to average between 3% and 4% over long periods.

Enter your result here:

$___________

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Step 3: Marshal your resources.

How are you going to come up with that amount of cash? Chances are you’ll have three sources of income: your company pension, Social Security and your own savings.

Can you rely on Social Security? Of course, it’s impossible to say for sure, but if you’re retiring in the fairly near future--any time within the next 10 to 15 years--you probably can. There is a great debate raging about what to do about the program in the future. But there are no current plans to dismantle it. If it is eventually revamped, there’s a good chance that the changes will be phased in gradually to protect those who relied on Social Security’s promise when doing their retirement planning.

However, if you are in your 20s, 30s or 40s, there’s a much better chance that massive systemic changes will severely erode your potential to receive substantial Social Security benefits. Although you may get something, many financial planners advise not to count on Social Security if you are under the age of 40.

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Step 4: Getting a benefit estimate.

To determine how much you’re likely to get from Social Security, request an estimate of monthly benefits from the Social Security Administration. How? Call the Social Security Administration at (800) 772-1213 from a touch-tone phone. That gives you a 24-hour recording, with several prompts. One allows you to request a “record of your earnings and future Social Security benefits.” If you follow the instructions, the agency will send you a short form that you’ll fill out, sign and return. A few weeks later, you’ll get a detailed report that estimates how much you’ll receive in monthly benefits. The report also explains your benefits, how many quarters of work you need to qualify for Social Security, how much you could receive in Social Security disability benefits if you were severely disabled and unable to work for a long period, and how much your spouse or survivors could receive by claiming benefits off your work record.

But recognize that the younger you are, the more speculative this figure is. There are two reasons why. First of all, you have a limited earnings history. And that earnings history--40 quarters of it, anyway--is used to determine your monthly benefits. If you expect to earn a lot more in the future than you do now, your actual benefits could be higher.

The second reason boils down to political tinkering. Congress can change Social Security rules, regulations and benefits any year from now until we all die. But legislation--particularly important, controversial legislation--tends to move at glacial speed. So a 50-year-old, who is between 12 and 15 years from collecting benefits (you can get reduced benefits at age 62), is at less risk of having benefits ripped out from under him or her than is a 30-year-old, who won’t be collecting benefits for another 35 years.

Still there’s no downside to requesting the estimate. It’s fast. It’s easy. There’s no limit to the number of estimates you can get, so you can request one again later if there are changes to your income or to the rules.

When you get the answer, enter it here. Monthly Social Security benefit:

$_________

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Step 5: Determining your pension payout.

If you have a company pension plan, call your employee benefits department and ask whether you’re “vested” in the plan and how much you could reasonably expect to collect at retirement. Chances are the answers will hinge on how long you have been with the company and how long you stay. Many people really won’t know the answer to the second part of that equation--at least not for a long time. Nonetheless, you make a guess--planning anything far into the future involves a significant amount of reasoned guesswork--and try to guess relatively conservatively, so that your future surprises will mainly be positive ones.

Your employee pension is likely to amount to a set percentage of your wages in the final three to five years of work. The percentage will depend on your income at that point and how many years you worked for the company. However, most company pensions also have Social Security offsets. What these do is reduce your pension amount by a percentage of the Social Security benefit you collect. For instance, if your company pension works out to $2,000 per month and your Social Security is $700 per month, your company’s Social Security offset may decrease your monthly pension by half of the Social Security amount. That would reduce your pension payments by $350 per month to $1,650 instead of $2,000.

Ask your employee benefits representative whether your company pension has a Social Security offset and how it could affect your monthly benefits. Enter your expected monthly pension amount here:

$_______________

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Step 6: Figuring a stipend from your savings.

If you already have some money socked away for retirement, you need to determine just how much this amount will be worth in the future. To do that, you need a present-value calculator. You don’t know how much interest the money will earn? Nobody does, really. But if you have a portfolio of both stocks and bonds and a long time horizon, it’s reasonable to use an 8% average annual rate. If your investments are mostly in bonds and fixed-interest accounts, you should expect to earn less--somewhere between 5% and 6%. If they’re mainly in stocks, you might earn more. But since stock market returns are less predictable--particularly over periods of a decade or less--it’s better to be conservative in your estimates. Using a rate ranging between 8% and 10% is fairly reasonable.

What will this savings account provide in monthly income? To answer that, you have to first consider whether you want to spend the account down to zero or if you want to live only on the interest income, leaving the principal alone for emergencies or your heirs.

If you want to leave the principal alone, multiply the future value by a reasonable interest rate--the rate you’d earn on fairly conservative income-producing investments that you’d be likely to invest in at retirement.

For example, if your savings account was likely to be worth $300,000 at retirement, you might multiply that by 6% to find that the annual income this account would generate would be about $18,000 annually or $1,500 per month. ($300,000 times 0.06 equals $18,000, divided by 12 months equals $1,500.)

If you plan to spend down the principal, you have to decide how much time you’ll take to do that. Let’s say you assume you’ll live 30 years after retirement, to age 95. So you plan to spend the retirement account to zero over that time. How much do you get monthly?

Enter your expected monthly income from your retirement savings here:

$_______________

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Step 7: The conclusion.

Your final step to determine your retirement readiness is to add up your estimated monthly Social Security benefits, your expected monthly pension benefits, and the monthly amount of income your retirement savings is likely to generate. Compare that total to the total you’ll need--the inflation-adjusted monthly income amount in Step 2.

If the expected income is higher than expected expenses, you’re in good shape. Just continue doing whatever you’re doing and you should retire comfortably. Be sure to check in on your retirement plan every few years, though, to make sure you remain on track.

If, on the other hand, your projected expenses are higher than projected income, you need to boost your savings or learn to live with less.

Adapted with permission from “Kathy Kristof’s Complete Book of Dollars and Sense” (Macmillan).