One of the most frequent questions we hear from clients is, “How much do we need to save for retirement?” While this question seems straightforward, knowing the right asset level for your needs can be challenging and requires a process. Most financial advisors use one of several methods to determine retirement goals for clients. To illustrate, I will demonstrate the Capital Needs Method. Before you start, a few base assumptions need to be made, which will be explained as we work through the equations. For your personal needs it’s worth considering these and doing some research before continuing.
Lets break these down.
Step 1: How Long Do You Plan on Working?
This is known as the Working Life Expectancy (WLE). It is not an arbitrary question. You need to consider your current health, the demands of your employment, desired lifestyle during retirement, among other things. One of the benefits of doing a Retirement Needs Analysis is being able to model the numbers under different scenarios to find a fit for your career, personal life, and goals. This is how we arrive at an illustration and make recommendations. For the sake of this illustration, we will use “20” years until retirement.
Step 2: Future Income Needs
We arrive at this number by taking your current income (Present Value, PV), the current Consumer Pricing Index rate of inflation (I), your time horizon until you retire (N) and compute these in a financial calculator. This will provide your future earnings needs adjusted for inflation. (Most advisors use Excel, the BA II Plus, or HP 12c calculators.)
Step 3: Wage Replacement Ratio
This is an estimate of your current income minus your current savings, usually 10% to 15%, and current Social security taxes being paid, usually 7.65% to 15.3%. Most advisors estimate that you will need 80% of your current income in retirement.
Wage Replacement Ratio: 80%
Annual Retirement Income Needed: $163,862 X 80% = $131,090
Another method for arriving at this number is known as the Budgeting Approach, which examines your current budget to determine actual spending. This method is typically more effective for clients very close to retirement because their costs during retirement are generally expected to remain the same or vary only slightly.
Now, we can determine exactly how much you’ll need to save for your desired timeframe/lifestyle.
Step 4: Capital Needs Method
We will be solving the equation for the total amount required to accomplish the goal of $131,090 in annual income. For this, we will be make (3) assumptions,
- Life Expectancy during retirement will be 20 years, from age 65 to 85.
- Our investment rate of return will be 8.5%
- We plan to leave no assets behind.
Step: 5: Breaking the Total into a Monthly Savings Goal
The crucial question: how much do you need to save monthly in order to accomplish this asset level?
If you have $0 in savings or retirement accounts:
If you already have $200,000 saved:
While these calculations are relatively simple, they do not account for the realities of potential equity market declines as in 2000, 2008, and 2020; and they cannot account for fluctuating inflation, tax rate increases, longer than expected life expectancy, etc. In other words, it’s difficult to account for varying outcomes that are typical in the real world using a Capital Needs Analysis. This is where financial planning software comes into play for most advisors.
Most planning software includes a Monte Carlo Analysis, a mathematical tool that illustrates multiple outcomes given some different scenarios entered. It then provides the probability of your desired outcome’s success. This results in the most likely of outcomes based on the data inputs. Utilizing Monte Carlo Analysis helps advisors increase clients’ probability of having successful retirement goals by increasing and decreasing (testing) the variables within the client’s control. When running such analysis, it quickly becomes apparent that clients may need to save more, reduce current spending, retire later, etc. The opposite can also be true. You may discover that you’re saving more than necessary and you can afford to increase your expenses (enjoy your money now) or retire sooner then you thought!
Using a Capital Needs Analysis is a great start towards getting on the path for a successful retirement. In addition, you can consider other sources of income you’ll have in retirement to offset your savings goal. According to an AARP survey taken in 2012, the two largest sources of income for seniors were Social Security (30.3%) and Earnings (37.7%) from part- or full-time employment. Income from investment assets was approximately 10.6% of total cash flow.
If you’re looking to get on track for retirement or are approaching retirement, it’s essential to consider all income sources in estimating your retirement needs.
For more information on how to get in touch with a Cary Stamp & Co. advisor, or for answers to questions, don’t hesitate to reach out to me directly at Andrew@CaryStamp.com.