Tuesday, November 13, 2012

Calculating Your Own Target Retirement Savings Amount

You can individualize your own target amount for retirement savings by using the replacement rates from the rightmost column in the following table from an Aon Consulting report, based on your final working income to the nearest $10,000 in the leftmost column.

This is the percentage of your final annual salary these consultants believe you will need to replace after you retire. Calculate your replacement amount by multiplying this replacement rate times the annual income you expect to be earning just before you retire (in today's dollars because your Social Security benefit will be quoted in today's dollar).

Calculate your expected Social Security benefits at the SSA website and convert this monthly estimate to an annual benefit by multiplying by 12. Your projected shortfall is the replacement amount minus your Social Security benefit.

How much savings would you need when you retire to buy the annual income to cover your shortfall? A good way to estimate this is to figure how much annual income you could receive if you used that money to purchase an inflation-indexed annuity from an insurance company.

Unfortunately, interest rates are historically low right now, so annuities are expensive. An inflation-protected annuity today would payout about 3.875% per year, or just $3,875 per year for every $100,000 of annuity you purchased.

Of course, there is no way of knowing how much annuities will be paying if you are going to retire several years from now, so this is only an estimate. On the positive side, annuities can’t get a lot more expensive than they are today, so this is probably a conservative estimate.

Here’s an example for someone earning $50,000 the year before they retire, with an estimated $21,000 a year of expected Social Security retirement benefits:.

a) Expected income the year before you retire in today's dollars
b) Replacement rate from Aon Consulting (see table)
c) Amount of final year income you will need to replace (a times b)
d) Expected annual household Social Security benefit from SSA.gov
e) Your retirement income shortfall
f) Current payout rate for inflation-protected life annuities
g) Amount you will need to save by retirement date (e divided by f)

If you’re lucky and these annuities are paying 5% when you retire, instead of 3.875%, the annuity would only cost $390,000. It’s unpredictable but critical variables like these that cause the estimates of the experts to vary so widely in the Table 1. They each use different assumptions for these variables.

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