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A good effort at calculating your retirement savings need.

I agree with you that the numbers tossed around by the investment/insurance industries that the media just loves to pick up and toss around some more, can seem to be excessive to many. But these 'averages' can be misleading, as it really depends on what household income you'll require during your retirement years, which in term will depend on life expectancy, average annual market returns and so on.

Having taught this subject at our local university based CFP course for the past 9 years, let me offer this 2 step approach to determine how much you'll need in your retirement savings accounts when you hit the magical first year of not having to get up and go in to work.

First, as you've done, one needs to make reasonable assumptions. Remember, we are dealing with an uncertain future, and the best we can do in planning for it is to start with assumptions that we feel are the 'best fit' or 'most likely' for our future:

- Average annual inflation rate and average annual wage inflation. Most planning calculations will only use one to represent both, although wage inflation is usually about 50 to 80 bp higher.

- Average annual rate of return. This should be different for accumulation years vs. retirement years. 8% today is a bit on the high side for accumulation years: 7 to 7.5% is more commonly used, likely due to anticipated slower economic growth over the next 20 years when compared to the past 20. During retirement this should drop to 5.5 - 6.5%, due to the higher bond (lower volatility) allocation.

- Age of anticipated retirement. Usually 62 to 65 or later, although this can vary on the type of employment and ability to retire.

- Life Expectancy. Multiple on-line sources for this, as you've pointed out. But also consider family longevity genes as well as genetic propensity to disease that will usually shorten life expectancy. much to you need?

Step 1: Grow current household income to first year of retirement, adjusting for SS benefit and for (usually) reduced household income need once retired. Take gross household income, reduce it by current SS retirement benefit and multiply this by a retirement income need factor, usually .7 to .8 (higher for low income households, lower for higher income households). then calculate the future value of this using suitable wage growth index. An example here will help:

Current household gross income: $100,000
Years to retirement (currently age 50): 12
Wage growth index: 3.1%
Current SS benefit estimate (both spouses): $34,000
Retirement income need: 75%

PV = (100000 - 34000)* .75 = $49,500 (note: SS benefit projection can be subtracted at this point from household gross income because it is indexed for inflation. If it were most private pensions are would have to project the annuity benefit at retirement and calculate its PV and subtract that from the capital need, or "the pot")
N = 12
I = 3.1
PMT = 0 (there is no "payment in this calculation"
calculate FV = $71,402

This represent the dollars your retirement savings will have to provide for you the FIRST year of retirement. But how big does the retirement "pot" have to be to be able to pay this amount, grown each year by inflation, through to your life expectancy?

Sept 2: Calculate capital need (the "pot") required

Life expectancy: 90
Expected average annual rate of return in retirement: 6.5%
Expected average annual CPI in retirement: 2.8%
Residual value of retirement savings at end of life: 0

Inflation adjusted average annual rate of return: ([1+Return]/[1+CPI])-1 X 100. So in this case: (1.065/1.028)-1 X 100 = 3.6%

N = 90 - 62 = 28
I = 3.6
PMT = 71402 (this is the amount your "pot" must provide the first year)
FV = 0
Calculate PV = $1,291,500

note: in using Excel or a Financial Calculator, you must set this annuity calc to "beginning of period", as retirement savings will be withdrawn at the beginning of the first retirement year, not the end.

If one is within a couple of years of retirement, it would be preferable to take the current gross household income and add/subtract expenses that you will have/no longer have due to your retirement...rather than using a 'retirement income need' percentage. Common examples of "adds" are travel, hobby and health insurance (if < age 65). Common "subtracts" are contributions to retirement plans, FICA tax, professional and commuting expenses...and perhaps health insurance if => age 65.

I can't run this using your numbers because I don't know your current and ages, although it looks like you might be born after 1960, as you're using age 67 (SS FRA for this group).

Now, clearly this is only a target, as there are multiple variables here that can change over time, greatly influencing the final value. Hence, this calc must be redone every few years to make sure that annual savings are sufficient. But imperfect that this may be, it certainly beats the alternative of guessing using some arbitrary % of salary as one's savings goal.

And FWIW, I strongly recommend those wishing to do this kind of calc invest in a financial calculator. I use Excel extensively, and know it reasonably well. But a FC is much easier to use and much, much faster. Its takes some time to learn, but they are worth it...and they're kind of fun to do 'what ifs' with. I recommend the BA II Plus Pro (which is now the required calculator for the CFA exam).

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