How Much Money Will You Need to Retire?

This article was made possible by support from OppenheimerFunds.

Planning for retirement seems like a daunting task. Calculations can be complex, especially if you want to be precise in projecting yearly cash flows over your lifetime. And considering all aspects of your financial picture can be overwhelming and confusing if you're uncertain about income needs, investment returns, inflation, tax rules, and government programs in retirement.

To make this process easy, I’ve put together a downloadable spreadsheet entitled “Retirement Planning in 4 Easy Steps” that should take just a few minutes to complete. You should have a clearer picture of your financial future and what steps you can now take so that you can live retirement in the style you want. (Note that for illustration, I have populated the spreadsheet with income and investment numbers.)

Step 1: Determine Annual Income Needed From Financial Investments During Retirement

Financial experts estimate that you will need 75% to 85% of your current annual income in retirement. These percentages may seem high, especially if you have acquired all the assets you think you’ll ever need by retirement age. Further, you might think that many expenses will disappear, like your mortgage payment, or they’ll shrink dramatically, like your grocery bill when your kids move away. But you’ll still have to pay property taxes, insurance, and maintenance on your house. Plus, higher expenses for healthcare and personal care may cancel out grocery savings, particularly if a family member develops a chronic illness.

Fortunately, you may have sources of annual income other than retirement accounts, like a pension or business revenue. Your retirement savings or nest egg, then, just needs to cover the difference between total income needed for retirement and income from other sources.

To determine annual income needed from financial investments, enter this information in the spreadsheet: current annual income, expected income from other sources, and percentage income needed in retirement, going lower if you plan to live frugally and will have paid off debt and higher if you desire to live luxuriously or will still have a mortgage in those later years.

Step 2: Calculate the Future Value of Current Retirement Savings and Annual Contributions to Retirement Funds

If you’ve already set aside money for retirement and are regularly saving money each year, figure out what those investments will be worth when you retire.

Enter the value of the retirement savings now, annual contributions to retirement savings, age now and at retirement, and expected investment return during your working years. Calculate the future value of your retirement savings if you simply stick to this plan of investment.

Step 3: Determine the Investment Value Needed to Fund Retirement Expenses

There are two schools of thought in determining the investment value needed for retirement. One approach is to save enough to spend investment returns and draw down the principal each year, depleting savings over your lifetime; ideally, you’ll die about the time you run out of money. The other method is to build a nest egg that allows you to live off the investment earnings and preserve the principal in case you live longer than expected. To keep the calculations simple, I have chosen the second method.

Enter your expected investment return in retirement and calculate the amount needed to generate the annual income to cover retirement expenses as specified in Step 1.

Step 4: Figure Out How Much to Increase Annual Savings to Meet Your Retirement Goals

After calculating how much investment in retirement savings you need, figure out how much extra to save to reach your goals. First, determine the shortage (or surplus if that applies); then calculate the additional amount to save and invest each year.

This approach is fairly simple, but ignores taxes, inflation, and investment risk. Inflation, in particular, can dramatically increase expenses and change retirement scenarios; for example, consider how inflation at 1% and 2% during your working years could increase later requirements for income, investment needed, and annual savings contributions.

To keep pace with inflation, consider increasing your savings as your income grows and pursuing higher investment returns during your working years, or discovering ways to reduce expenses in retirement.

Fluctuations in investment returns can also affect the viability of retirement plans. For simplicity, the spreadsheet uses a reasonable but not guaranteed investment return during your working years (6%) and a slightly higher rate in retirement (8%). But if the investment return was 7% or 6% in retirement, you would have to save more each year. 

To earn such returns and still protect your retirement funds, allocate your money to higher-return, higher-risk investments, such as stocks, mutual funds, ETFs, etc. (keeping in mind that these investments may lose rather than gain in value) and lower-risk, lower-return savings, such as bank CDs, savings accounts, money market funds, treasury bills, or corporate bonds. To generate an overall return of 7%, for example, equities of $400,000 would need to earn 10% combined with a 1% return of $200,000 in a savings account.

So don’t ignore retirement-planning wild-cards like inflation or uneven investment growth. But don’t let fear or uncertainty about the future keep you from taking easy steps toward retirement now.