This post originally ran on 4/17/2013, before (almost) anyone was reading this blog. I’m re-running it now with updated content because I think it’s an important topic.
“Simplicity is the ultimate sophistication”
-Leonardo Da Vinci
You already know that you’re supposed to be saving for retirement. I’m not breaking any ground by saying it here.
But how much should you be saving? Ahh, now there’s the million dollar question.
You’ll get a million different answers all over the internet. But most of the are burdened by at least one glaring weakness:
-They’re too generic don’t take into account the specifics of your situation,
-They give you a retirement “number” to shoot for, but don’t help you figure out how much you should be saving to get there, or
-They make you guess at a lot of variables, a complexity that makes them hard to understand AND more likely to give a false answer.
My goal is to help you figure out how much you should be saving, today, in order to reach the retirement you want.
The method I give you here addresses each of the weaknesses above. It’s personal, it gives you a monthly contribution to shoot for, and it’s simple enough to actually understand while still giving you a meaningful result.
I’ll be upfront, if you’re closing in on your retirement date then this is not the article for you. You’ll need more precision then what’s included here.
But if retirement is still a couple of decades away, this will give you a great start. There’s a calculator and everything, so figuring out your target savings is as simple as possible.
So, without further ado, here’s the easy way to create your very own retirement plan.
Step 1: Embrace the uncertainty
Let me get this out of the way right from the beginning.
As a young investor with many years before you actually retire, there are a TON of variables that can affect your plan along the way. Many of these variables will change over the next several decades, which will require your plan to change along with them.
There’s a lot of uncertainty in whatever plan you come up with now, and that can be scary.
But the best thing you can do is embrace the uncertainty. Acknowledge the fact that, no, you can’t know how those variables will play out ahead of time. You just can’t.
But what you can do is get started with the small number of things you DO know today. Keep it simple, get started, and know that you’ll have to make adjustments along the way.
And before you start feeling guilty, this isn’t lazy. It’s actually smart. It’s a recognition that there are certain things you in life you can’t know and can’t control. And by being adult enough to recognize that, you’re able to cut out all the useless complexity that might otherwise make this process a lot more difficult than it has to be.
So, let’s get started.
Step 2: Estimate your monthly expenses
Start with your current monthly expenses. You start with expenses rather than income because it’s your spending that matters in retirement, not whatever you happen to be making today.
If you’re already keeping a budget or tracking your spending then you’ll have these numbers handy.
If not, make as good a guess as you can right now. But if you want a more accurate result, I would spend a month or two simply tracking your spending (not necessarily budgeting) to get an idea of what it looks like. I use mint.com to do this for my own expenses and find that it makes the process pretty easy.
Here are some specific things to both include and not include in this number:
Do include
Any “saving to spend” contributions for things like car repairs, home maintenance and travel
Health insurance premiums taken out of your paycheck
1/12 of any annual payments for things like car insurance
Do not include
Retirement savings contributions
College savings contributions
Step 3: Estimate the Social Security you’ll receive in retirement
As my friend Alan Moore pointed out in response to my article comparing Traditional to Roth IRAs, Social Security is more alive and well than many people believe. Even if nothing is done to fix the system, it should still be able to pay out at least 70% of the current estimated benefits for the rest of the century. So it makes sense to include it as part of our evaluation.
There are two different ways to get your estimated Social Security income. Both are described below.
If you have a spouse, you can both go through this exercise and sum the two numbers together.
For people who have enough work credits AND expect their income to stay relatively steady (try this one first)
Follow the step-by-step instructions laid out here: How to Check Your Social Security Benefits.
When you check your “Estimated Benefits”, you’ll see three numbers for retirement depending on what age you plan to retire. Unless you have a known reason to do otherwise, use the amount labeled as “At full retirement age (67)”.
If you don’t have any estimated benefits, or if you expect your income to dramatically change in the future, use this next method instead.
For people who EITHER don’t have enough work credits OR expect a significant change in income
You might go through the process above and find out that you haven’t earned enough work credits for them to give you an estimate. Or you might have good reason to expect your income to change significantly in the near future.
In either case, you’ll need to go through a few extra steps to get a reasonable estimate for Social Security.
Just as above, follow the step-by-step instructions laid out here: How to Check Your Social Security Benefits.
This time, click on the tab labeled “Earnings Record”. Keep this tab open. You’ll use it in a minute.
In a new browser window, go here: Social Security Benefit Calculator.
Fill out the information requested. Here are a few important notes:
Unless you have a known reason to do otherwise, enter your “Age at retirement” as 67. This doesn’t actually have to be your planned retirement age. It’s just a helpful baseline for estimating your benefit.
Leave the “Today’s dollars or future dollars” box marked as “today’s dollars”.
For the “Annual earnings” boxes, you can refer back to the “Earnings Record” you opened up in Step 2 to fill in your income from previous years.
For “Earnings in 2015 and later“, this is where you enter your estimate for your long-term annual income. This will only significantly change the result if it’s significantly different from what you’ve been earning to this point.
After filling out that information, your estimated monthly retirement income is in the box labeled “Your monthly retirement benefit” in the “Benefit estimates” section.
Step 4: Estimate the monthly savings needed to produce that retirement income
Okay, now you’ve got the important variables and you’re ready to figure out how much you need to be contributing to reach your retirement goal.
I’ve include a Retirement Contribution Calculator at the bottom of this post to make it easy for you. Just follow the instructions here:
Enter your “Current age“.
Enter your “Estimated retirement age“. This doesn’t have to be age 67 even though that’s the age you used for Social Security. It can be any age you want.
Enter your “Estimated monthly expenses” calculated in Step 2 above.
Enter your “Estimated monthly Social Security income“ calculated in Step 3 above. Please enter this as the full amount you found in Step 3, though the calculator will only include 50% of it (to be conservative).
Enter your ”Current retirement savings balance“, which is simply the sum of all of your accounts earmarked for retirement (things like a 401(k) and IRA).
Enter the percent of your investments you expect to put into stocks in the “% of money invested in stocks” field. The calculator a very simple asset allocation split between stocks and bonds. If you have other types of investments (non-stocks or bonds), a rough estimate here is good enough. You can refer to this article on determining your asset allocation if you need some help coming up with this number.
Once you’ve entered your numbers into each of those fields, the “Monthly retirement savings target” field will display the monthly contribution needed to reach your retirement goal.
This contribution amount should form the basis of your current retirement plan. It’s the one thing you can control that will make the biggest impact towards reaching your retirement goal.
Step 5: Start investing
Knowing how much you need to contribute is one thing, but actually making it happen is another.
Most importantly, don’t worry too much if you can’t hit that savings target right now. Just do what you can to get started and keep an eye on increasing your contributions when you can along the way. You can always revisit this calculator again in the future to re-evaluate, but simply getting started is a huge step.
In terms actually choosing where and how to invest, if you’re new to investing then I would start with these two articles:
-How to Start Investing, Part 1
-How to Start Investing, Part 2
If you’d like to dig a little deeper, I have an investment page which organizes the best posts I’ve written on investing and should give you plenty of information to get started. You can find it here: Invest in your family’s future.
Don’t worry about picking the “perfect” investment strategy. The truth is that the perfect strategy doesn’t exist. Shoot for something that feels right to you and fits within the general guidelines described in the posts linked just above.
Your goal should be to pick something “good enough” and simply get started making those contributions.
Step 6: And you’re done! Well, for now.
Really, that’s all you need to know. There are an infinite number of ways you can make it more complicated, but at the core you will always be doing some variation of this.
As your circumstances change, and they absolutely will, your needs may change. No problem. Simply revisit these steps and see what adjustments need to be made.
It’s important to understand that this simply gets you on the right track. It uses ballpark estimations and it offers no promise or certainty. But it’s just as important to understand that the certainty you might be looking for really doesn’t exist, and this method will get you much closer than most.
So take these steps, set up your contributions, and get back to all those other things taking up your time. You can forget about that nagging retirement problem for a little while.
Retirement Contribution Calculator
**Assumptions
-Stock return = 7%
-Bond return = 3.60%
-Inflation = 2.25%
-Withdrawal rate in retirement = 4%
-Stock return was informed by the numbers in this tool
-Bond return and inflation numbers were taken from yields on 30-year nominal Treasuries and TIPS as of 2/27/2014 (Source 1, Source 2)
-The Social Security benefit is cut in half and computed as a present value, as described in this article.
Photo courtesy of Keoni Cabral
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