I find when meeting with individuals for the first time that they typically have no idea how much they will need to be able to retire. The typical answer of $1 million is absolutely worthless since everyone has different income requirements and different income sources that must be added into the equation when determining when and how much will be necessary.
The first step is to take a complete inventory of all your assets currently earmarked for retirement, such as pension income, retirement assets, and Social Security income, that will be utilized to create a retirement income stream. Social Security typically makes up about one-third of a retiree's income. For many, this is the main source or largest source of income. It's important to get your Social Security filing strategy correct, as well as incorporate this projected amount into your overall retirement income projection. Simple calculators are fine to give an indication of how long your Social Security benefit will last, but you must integrate all your income sources together and deploy smart income planning strategies.
The next step is to determine what net annual income will be necessary upon retirement. The easiest method I have seen is simply to review a current pay stub and use the "net income" on the pay stub as a good starting point to know how much money is needed in retirement to maintain your lifestyle. I recommend this because some expenses may go up in retirement and some may go down. Many clients might not want to change their lifestyle in retirement, i.e., they want to live off the same income pre- and post-retirement. It's all part of the discovery process, but I err on the side of overestimating these needs initially. Next, add up all monthly income sources and subtract this from your net paycheck needs to determine how much income will be required from your retirement portfolio.
Let's use the following hypothetical example for someone contemplating retiring at 65 years old:
A. Determine the net income from income-producing retirement assets
Take an inventory of all income-producing assets currently earmarked for retirement:
$1,200 per month from Social Security + $600 per month from pension plan = $1,800 per month
Now we must figure out the estimated tax payable on the income sources earmarked for retirement. We will assume the Social Security Income of $1,200 for this couple is non-taxable since the total income level is below the threshold to make the Social Security income taxable. In addition, we will assume the $600 monthly income from the pension is taxable at an effective or marginal tax rate of 15%. We will estimate the tax on this monthly income at $90 ($600 * 15% tax) which leaves $510 as the net income provided by the monthly pension. We now must add the monthly Social Security income to the net (after-tax) pension income which will provide a total monthly income of $1,710 per month ($1,200 Social Security income plus $510 pension income).
B. Determine the Net Retirement Income Needed (monthly) from pay stub
For our example, let's say the figure is $4,000 per month.
C. Determine the net income needed from investments
The difference between the $4,000 net income needed and $1,710 net income provided from the Social Security income and net pension income = $2,290 per month net monthly income needed, or $27,480 annual income needed after tax (net).
D.Determine the investment portfolio necessary to provide the $27,480 net after-tax income
Now we must determine what amount of retirement savings is necessary to provide $27,480 per year of net income, but we mustn't forget about taxes. At a 15% effective or marginal tax rate, this brings the need to $32,330 gross income, as $32,330 – 15% tax = $27,480 net income provided.
According to a recent report from Morningstar Investment Research entitled Low Bond Yields and Safe Portfolio Withdrawal Rates, a safe benchmark for withdrawing from a balanced retirement nest egg is a rate of approximately 2.5% per year. According to the study, this would give a retiree a 3% inflation increase per year investing in a portfolio made up of 60% stocks and 40% bonds and would stand a high probability of lasting through a 30-year retirement.
For our final step, we must divide $32,330 by 2.5%, which gives us $1,293,200. That figure would yield the $27,480 annual after-tax income needed to supplement the Social Security and pension plan income.
Tomorrow, I'll go a little deeper behind the methodology.
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