The rest of this section deals with handling your money well. This one chapter addresses your goals; putting them in quantifiable terms and calculating how much you need to save to achieve them.
If your needs and wants are already well taken care of, you need only focus on maximizing returns and eliminating scams. You can skip this chapter.
If you have doubts about the ability of your financial resources to meet your needs and wants for the rest of your life, read on.
Understand your financial situation
You can easily discover the financial status of any publicly traded company by viewing its balance sheet and income statement. A balance sheet shows assets, debt and net worth as of a particular date. An income statement reports flows of income, expenses and the net change to your net worth during a particular period. In a very simple format, you should have similar cognizance of your own situation.
To create your balance sheet, list the total balances from your bank, brokerage, and employer retirement statements. These are the “liquid” assets you can invest. Separately, list other substantial assets such as a home, car, collectibles and such. Estimate their value. The total of these estimates plus your liquid assets are your total assets. Now list all loan and credit card balances. Add these to get your total debt. Subtract total debt from total assets. The result is your net worth.
Going forward, income and asset growth will add to your worth. Investment losses and expenses – including financial fees and debt costs – will take away from it.
Know the key dollar figure you should aim for
As a minimum goal, you want your net worth to be a positive number when you pass after having paid for all of the things you need. A better goal: a positive net worth when you pass after having done all the things you want. Even better: do all those things and leave substantial net assets to others to help them achieve their goals and dreams.
Most of us face a life cycle with two adult financial phases: a period during which we earn money and add to our worth followed by retirement, a period in which we might find ourselves draining assets. There could be intermittent variations from that model, such as spans of unemployment or years in which big health or education expenses hit. But those financially rainy days are just bumpy parts of a road leading to the end of our working life. At some point, you will probably begin a long spell of reliance on non-wage income.
You may be able to keep wealth growing until your final days. If you are not yet in that position, if your anticipated expenses exceed your expected future income, before retirement your savings must get to a level adequate to meet your needs for the rest of your life.
What do you need?
To determine how much you need to invest, it is helpful to divide your financial goals between things you need versus those you want. Only you will know the difference.
For instance, you need money for food, shelter and medical expenses. You probably also need to cover the costs of transportation, insurance, education, maintenance, and clothing. Some minimal amount for recreation could also be considered a need.
Assign dollar amounts to these things. When in doubt as to “how much”, choose higher amounts. While there will be good things not predicted in your budget, bad things happen, too.
What do you want?
Do you want to upgrade your ‘needs’, e.g. with a bigger home or more nights eating out? Do you want to travel more? Are there charitable causes you would like to advance? Do you want to enhance your children’s wellbeing while you are around, and afterward?
For each dream there is a definable range of costs. Similar to planning for life’s needs, you can add these costs into your calculations to help some dreams become reality.
How do you get there?
An online planning application or well-organized spreadsheet can help you calculate the amount you need to accumulate before retirement. Similar tools can assist the calculation of saving patterns needed to reach this amount and other goals, such as funding school or buying a home. You are encouraged to seek and utilize such tools.
But to provide a complete picture herewith, the rest of this chapter shows a framework you can use to estimate how much you will need upon retirement and how much you need to save before you get there. If you already have a grasp on your retirement resources or you are not in the mood for math, move on to Chapter 45. You can always come back.
How much will you need upon retirement?
When calculating what you need to save to cover retirement expenses, remember to factor in other resources such as Social Security and savings already accumulated.
Moving forward, Figure 44-3 shows how much you need to accumulate by retirement to cover $1,000 per month in expenses until you are 100 years old. You can see the impact of retiring at different ages and the effect of earning different rates of return.
For example, if you stop working at age 70 and earn 5% going forward, a balance of $186,282 as of your retirement date would provide income of $1,000 per month for the next 30 years. If you stopped work at 65 and earn only 3% in the years ensuing, you’d need $259,841 in the account to pull out $1,000 per month for the next 35 years.
How much more do you need to accumulate?
You may already have assets invested. In the same way Social Security helps cover expenses, your accumulated savings bring you closer to targeted future goals. Figure 44-4 shows how $10,000 currently invested grows over time with various return assumptions.
With 30 years left to retirement, Figure 44-4 shows that at 5% your $10,000 will grow to $43,219. At 7%, your $10,000 would instead grow to $76,123.
How much should you save to reach your target?
Figure 44-5 shows the amount you need to save each month to accumulate $100,000 at some point in the future. You can see the impact of time and different rates of return.
If you’re 40 now and plan to retire at 70 you have 30 years to save. If your investments earn 7%, saving $82 per month would get your portfolio from nothing to $100,000. If you earn only 3% instead, you would need to put away $172 per month to get to $100,000 over the same period.
Example 1: Putting this all together
Assume you are 40 years old, plan to retire at 70, have $50,000 saved for retirement and expect Social Security benefits of $2,000 per month. You estimate desired retirement spending to be about $5,000 per month. Analyzing your tolerance for risk (Chapter 45), you see the proportion of stocks and bonds appropriate for you historically averaged 5% returns (Appendix C). Under these assumptions, what do you need to start saving each month to make retirement everything you want it to be?
Your desired retirement lifestyle of $5,000 per month is partly offset by Social Security of $2,000; you will need your financial assets to generate $3,000 per month from the time you are 70 until you are 100. Using Figure 44-3, 5% returns and the 70 retirement age, you see $186,282 is needed for $1,000 per month. For $3,000, you’ll need to accumulate three times $186,282, or $558,846.
You already have $50,000 in your portfolio. Figure 44-4 shows $10,000 growing to $43,219 in 30 years at 5%. Your $50,000 would grow to five times that number, or $216,095. Thus means $216,095 of your $558,846 target is already taken care of. Your new savings need only grow to the difference, $342,751.
Lastly, referring to Figure 44-5, $120 deposited monthly earning 5% will grow to $100,000 in 30 years. Since you need to raise $342,751 by then, multiply $120 by 3.42751 ($342,751 divided by $100,000) to get $411– the amount you should put away each month.
Summarizing this example, depositing $411 each month into investments earning 5% for the next 30 years produces an ending balance of $342,751. Your current balance of $50,000 already invested at 5% will grow to $216,095. Those two balances add up to $558,846. This $558,846 will allow withdrawals of $3,000 per month from age 70 through age 100, supplementing Social Security payments of $2,000 for total monthly income of $5,000. So under these assumptions, saving $411 each month starting now will allow your retirement to be all that you want it to be.
Round numbers to save time and gain security
No one knows what the future holds. The rate of return on your portfolio will not be exactly 5% or any other guessed number. The economy will flourish and falter. Your budget will change, as will tax laws and life expectancy. Meanwhile health, opportunity and technology may affect your retirement date.
The calculations described so far may be accurate, but they represent guideposts to mark minimums. To ease the math and build a cushion, round up your expenses and round down your returns.
Example 2: A simplified approach
Consider the example just cited: You are 40 years old, have $50,000 saved, expect 5% returns, and hope to retire at 70 with Social Security benefits of $2,000 per month and anticipated retirement expenses of $5,000 per month.
Per $1,000 in monthly income, Figure 44-3 indicates a needed retirement balance of $186,282 (age 70, 5% ROR). Round this up to $200,000, and then multiply by 3 for the $3,000 excess expense you seek to cover. This gives you a target accumulation of $600,000.
Addressing your current savings, Figure 44-4 indicates $10,000 grows to $43,219 after 30 years at 5%. Round this down to $40,000, then multiply by five (you have five times $10,000) to estimate an ending value of $200,000. Subtracting this from your needed accumulation of $600,000, your target future balance for new savings is $400,000.
Looking at Figure 44-5, you find $120 per month will grow to $100,000 at 5% over 30 years. You need $400,000, so you should start saving $480 ($120 times 4) per month to meet your goals, with much room for error. Of course, you are always encouraged to save more than the formulas indicate, with or without rounding.
Now, knowing how much to save, the rest of this section will help you invest it well.