Maybe you're just starting your working years. Perhaps you're in the midst of raising a family, buying your first home, or funding college for your kids. In these situations, it's common to believe, "I can't afford to save for retirement now."
We'd say, "If you hope to retire some day, you can't afford not to save!" Here are some of the reasons retirement saving should be a top priority - and the questions to ask yourself as you get a real sense for what it will take in dollar terms to retire:
Retirement may last longer than you think
Average life expectancy is rising - a child born in the US in 2002 has an average life expectancy of 77.3. Even today, once you've reached age 65, you can expect to reach age 81 if you're a man and 84 if you're a woman.1
Keep in mind, as well, that few people are "average." An individual has a 50/50 chance of outliving the average life expectancy. So for many people working today, retirement may last as long as their careers.
Consider your own health and family history as you plan for retirement. Don't underestimate how long you may need to have income once you've stopped working.
Inflation reduces the value of your savings
As prices rise, a dollar buys less. That's inflation, simply put, and over time it can eat into the value of your retirement savings.
So, keeping your savings growing to stay ahead of inflation is another retirement investing challenge.
Health care costs continue to rise
You see it already in your own pay stub if you work for a large company or in your bills if you're self-employed or not covered by an employer plan. Health insurance is expensive and not getting cheaper.
As you think about what it will cost to retire, consider that advances in medical science are now resulting in longer life - and with it, the increased possibility of assisted living and skilled nursing expenses.
In addition, keep in mind that you'll likely be paying a larger percentage of your own health care bills2:
- Right now, just over a third of private employers offer retiree health benefits, and according to a survey by the U.S. Department of Health and Human Services, more than 80% of those employers are considering reducing the benefits within the next five years.
- In general, Medicare covers less than half of medical expenses, so you may want to plan for "medigap" insurance-supplemental health insurance issued by private companies. To get an idea of how much this coverage might cost in the future, check with your state's insurance department to learn what current costs are - then project increases based on your age now.
Be realistic about how much income your savings can provide
Many financial advisors now recommend relying on just 3%-4% of retirement assets each year for income.
Before sophisticated computer technology made it possible to do thousands of calculations simultaneously, investors used a common rule of thumb to estimate how much income their savings might provide. They assumed an average annual investment return - often 8% - an average annual inflation rate - say 2% - and figured they could safely withdraw the remaining "gain" - say 6% - each year without touching principal. The averages commonly used were based on historical patterns.
Averages aren't reality, of course. Now, powerful computer simulations and analysis make it possible to test many different hypothetical rates of return and many different hypothetical inflation rates for differently diversified hypothetical investment portfolios over long periods of time. Allowance can be made for beginning retirement in a bear market or a bull market or something in between.
As a result, if there's a rule of thumb about income, it's now far more conservative:
- Assume you may be able to rely on just 3%-4% of retirement assets for income in the first year of retirement.
- Assume your retirement income can vary from year to year- sometimes substantially - since it will depend on the value of your savings each year.
How much might you need to support your retirement?
In addition to longer lives and more expensive health care, retirees need to consider the normal expenses of day-to-day living. Their nature might change - from no more commuting-related costs, no business wardrobe, and no kids at home, to more travel, more leisure, and more entertainment - but you'll still have expenses. Then there are taxes, which don't stop just because you stop working.
Generally, financial planners advise that you anticipate needing income during retirement equal to between 70% and 80% of your income at retirement. Unless you're now close to retirement, you probably don't have a clue about what you'll be making when you retire. But it's worth your time to estimate. Take four simple steps to do it now:
- Analyze your current expenditures - not to the penny, but certainly learn where your money goes today.
- Work through what seem to be logical scenarios for where your current and hoped-for jobs can take you. Then make an educated guess at how much they might pay.
- Project how much a dollar in today's money might be worth in the period when you hope to retire. (Historically, inflation has averaged about 3% annually.)
- Once you have a sense for income at retirement, begin considering whether 70% or 80% of that number might be adequate to meet your income needs in retirement. Think about what you might do with your time once you're not locked in to a work-related schedule every day. Again, it may be hard to anticipate correctly, but give it your best shot so you're not doing retirement planning in a vacuum.
Where will you get the money?
Right now, Americans age 65 and older rely primarily on four sources for income in retirement:
For younger Americans - those now beginning to plan for retirement - dependence on two of these three sources may not be realistic:
- The concept of company pensions wasn't even introduced until 1900, and by the 1980s employers were already beginning to replacing defined-benefit plans with defined-contribution plans like 401(k)s.
- Social Security didn't exist before 1935, and its future may be in jeopardy unless significant changes are made to the system. In any case, as the Social Security Administration itself says, benefits were "never meant to be the sole source of income in retirement."
Planning for retirement today means focusing on personal and retirement-plan savings. While it's likely that some form of Social Security may remain intact, personal savings will probably represent a larger portion of retirement income for you than it did for your parents. If your employer offers a company retirement savings plan, be sure to contribute. And make the maximum allowable contribution to an IRA annually.
Fortunately, to meet the many challenges of retirement saving, there are many sources of assistance.
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