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lump sum number is to multiply the shortfall by 25 years: ($40,000 X 25 = $1,000,000). The 25-year number is derived by dividing 100 percent by 4 percent.
From the $1 million, subtract your current savings to determine how much you need to accumulate. You can estimate that part of your accumulation will come from growth of your current investments. If you subtract that potential growth, you will arrive at the additional savings you need. For example, if you have already saved $600,000 and you expect those savings to grow to $765,000 prior to retirement, the savings target becomes $235,000: your savings goal during your remaining working years. Note: If you are planning to retire before you receive Social Security or a pension, you will have to plan for additional outlays from savings in your initial retirement years and adjust the numbers accordingly.
A WARNING ABOUT USING SCIENCE IN FINANCIAL PLANNING
Scientific formulas are fine for physics, where there are rigid laws of nature. But they can give you false information in the subjective world of financial planning. The simple method for calculating your number has many assumptions built into the formula, some of which may not be realistic. For example, a 4 percent income level from investments assumes that you desire to have your heirs inherit every dime you ever saved after inflation. If leaving every penny to heirs is not part of your estate plan, or you do not care what anyone gets after you are gone, then you could take out more money without worry. Perhaps you could take out 5 percent per year rather than 4 percent. In that case, you would multiply your income shortfall by 20 rather than 25 to find the number.
Also, the idea that someone is going to spend the same amount of money at age 65 as they do at age 85 is simply not realistic. Department of Labor surveys show that spending goes down with age, particularly when people get into their 80s. At that point, people start to downsize by selling the second car and selling the second home; they do not travel as much or go out to eat as much. Adjustments can and should be made to the number to approximate these decreasing spending habits. Perhaps a realistic number is closer to 17 or 18 times annual income shortfall rather than the rule of thumb of 25 times.
To assure that your retirement assets provide for 30 to 40 years of retirement, you need to do a new calculation each year and adjust for inflation accordingly. These readjustments to your goal account for market fluctuations and other factors that affect your ability to save for retirement. Downsizing and/or relocating to a less costly area are additional means of reducing the difference between total annual income in retirement and the amount indicated as a safe withdrawal from your savings.
Even if you spend considerable time and effort calculating a savings number that will produce a safe, sustainable withdrawal rate in retirement, it is prudent to note an important caveat: Applying rigid scientific formulas to finance are helpful in that they are conceptual, but those formulas cannot account for the unknowns.
Compound interest calculators and savings calculators can project average returns over time, but they cannot project the impact of a major market downturn in the years just before retirement. Nor can they project the loss of a job or a severe decline in real estate values for someone hoping to relocate.
Many financial planners use complex Monte Carlo simulation analysis to predict the probability of successful withdrawal rates, taking into account past inflation and market performance. But those formulas are built around strict scientific laws that do not apply to future economic events. Monte Carlo simulation cannot forecast changes in the tax code, the bankruptcy of a pension plan, or an inheritance.
BUDGETING FOR RETIREMENT
How do you budget for the seemingly staggering amounts needed for retirement? If you are a young investor just starting out,
From the $1 million, subtract your current savings to determine how much you need to accumulate. You can estimate that part of your accumulation will come from growth of your current investments. If you subtract that potential growth, you will arrive at the additional savings you need. For example, if you have already saved $600,000 and you expect those savings to grow to $765,000 prior to retirement, the savings target becomes $235,000: your savings goal during your remaining working years. Note: If you are planning to retire before you receive Social Security or a pension, you will have to plan for additional outlays from savings in your initial retirement years and adjust the numbers accordingly.
A WARNING ABOUT USING SCIENCE IN FINANCIAL PLANNING
Scientific formulas are fine for physics, where there are rigid laws of nature. But they can give you false information in the subjective world of financial planning. The simple method for calculating your number has many assumptions built into the formula, some of which may not be realistic. For example, a 4 percent income level from investments assumes that you desire to have your heirs inherit every dime you ever saved after inflation. If leaving every penny to heirs is not part of your estate plan, or you do not care what anyone gets after you are gone, then you could take out more money without worry. Perhaps you could take out 5 percent per year rather than 4 percent. In that case, you would multiply your income shortfall by 20 rather than 25 to find the number.
Also, the idea that someone is going to spend the same amount of money at age 65 as they do at age 85 is simply not realistic. Department of Labor surveys show that spending goes down with age, particularly when people get into their 80s. At that point, people start to downsize by selling the second car and selling the second home; they do not travel as much or go out to eat as much. Adjustments can and should be made to the number to approximate these decreasing spending habits. Perhaps a realistic number is closer to 17 or 18 times annual income shortfall rather than the rule of thumb of 25 times.
To assure that your retirement assets provide for 30 to 40 years of retirement, you need to do a new calculation each year and adjust for inflation accordingly. These readjustments to your goal account for market fluctuations and other factors that affect your ability to save for retirement. Downsizing and/or relocating to a less costly area are additional means of reducing the difference between total annual income in retirement and the amount indicated as a safe withdrawal from your savings.
Even if you spend considerable time and effort calculating a savings number that will produce a safe, sustainable withdrawal rate in retirement, it is prudent to note an important caveat: Applying rigid scientific formulas to finance are helpful in that they are conceptual, but those formulas cannot account for the unknowns.
Compound interest calculators and savings calculators can project average returns over time, but they cannot project the impact of a major market downturn in the years just before retirement. Nor can they project the loss of a job or a severe decline in real estate values for someone hoping to relocate.
Many financial planners use complex Monte Carlo simulation analysis to predict the probability of successful withdrawal rates, taking into account past inflation and market performance. But those formulas are built around strict scientific laws that do not apply to future economic events. Monte Carlo simulation cannot forecast changes in the tax code, the bankruptcy of a pension plan, or an inheritance.
BUDGETING FOR RETIREMENT
How do you budget for the seemingly staggering amounts needed for retirement? If you are a young investor just starting out,
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