Most people understand that the sooner they begin planning for retirement the better, but the question invariably arises, "How much money will I need for retirement?" This is obviously a very important question, but it is also one that is very difficult to answer.
National Insurance, your company-sponsored pension plan, personal savings, longer life expectancy, inflation and your retirement needs (what you want out of retirement) are all factors that should be considered when determining how much you'll need to save for a comfortable retirement. It is however very important to get a handle on your current expenses as it is this component that will help you decide how much money you'll need. The problem is many individuals don't have any idea about what their expenses will be, hence they usually underestimate what their savings should be. Also, many individuals don't take medical costs into consideration or don't focus enough on the risk posed by inflation. Additionally, one of the most neglected facets of retirement planning is longevity risk. With the modern advances in medical technology, people are living longer than the country's standard life expectancy. Once you've considered all of these factors and gotten a good handle on your annual retirement expenses, you can then determine how you might pay for those expenses and thus, how much you will need to save for retirement.
It is estimated that an individual entering retirement will need approximately 70% of their pre-retirement income each year after they retire, to enjoy the same lifestyle they had while they were employed. However, if you look at what an individual may want to do when they retire, for example, increase travel or take up an expensive hobby, the 70% replacement income factor jumps to 100%. To take this one step further, individuals who retire before paying off their mortgage will need about 120% of their pre-retirement income to enjoy the same standard of living that they previously did.
Accurate estimates of expenses and income are invaluable as you plan your retirement and determine your savings need. After you've determined what you think you'll need to live on during retirement (expenses), one rule of thumb is to multiply it by 25. For example, if you think you'll need $40,000 a year, you'll need 25 times that amount or $1,000,000 in order to retire comfortably. Next, you need to consider what you are eligible to receive from National Insurance and/or your company pension plan, then identify their annual value and subtract that from your annual retirement expense. What's left is the amount of living expenses that must be made up either by investment income or other sources of income.
For example, if you expect to receive approximately $12,000 from National Insurance benefits each year and $8,000 in an annual pension from your company sponsored pension plan, you will only need half of the $40,000 each year from your savings. Since you'll only plan on pulling out about $20,000 each year, you'd need about $500,000 saved by your retirement date.
After determining your income gap (in this scenario $500,000 by your retirement date) you can easily calculate what you need to save to achieve your goal.
Another factor that will help you determine how much money you will need for retirement is to determine when you actually plan to retire. The younger you are when you retire, the longer you can expect to live during retirement. This means you need to have a lot more money saved. If you wait longer until retirement, not only will you be retired for a shorter amount of time, but you will also work more years, meaning you can save more. The younger you are and the more you have saved, the less you'll need to save in the future in order to achieve the same retirement standard of living as someone older or with less money saved up until that point.
This rule of thumb is not a rule of law but merely a guide. Everyone's retirement goals are personal and no one gets into trouble because they saved too much too soon. When it comes to how much savings you'll need for retirement, putting away more money while you're working, and working more years before retiring is a good form of insurance for ensuring a comfortable retirement.
Sean K. Longley, CPA is Vice President, Business Development/Client Relations - CFAL, a member of the AF Holdings Group of Companies.