Financial security is something everyone wants to achieve in their retirement years. Whether you are just starting out on your retirement journey or you're well on your way, calculating how much you will need can be tricky. Several methods exist for determining the number that represents the amount you need for retirement. The replacement ratio method and the adjusted expense method are two of the more popular ways to determine how much you will need.
Calculating the Replacement Ratio
The replacement ratio method for calculating retirement is based on surveys that indicate the average retiree needs about 75 to 80 percent of their salary after they retire. According to AARP, the rule of thumb is that you'll need roughly 80 percent of your pre-retirement income when you leave your job. This means that if your combined income is $90,000, then the amount you need to live on after retirement is $72,000. If you think that you will live to be 85 and retire at 65, then you need $1,440,000 to retire and live comfortably.
This method is excellent for giving you a ballpark figure, but it uses the assumption that your financial circumstances will remain relatively the same. It does not account for things like inflation and rising costs. It is based on a constant amount that represents a snapshot of your current circumstances.
This method gives you a conservative estimate. Therefore, you might want to consider factoring in rising costs, inflation and expenses that you plan to eliminate after you retire.
Calculating the Adjusted Expense Method
A second popular method for calculating how much you need for retirement is the adjusted expense method. This method is a little more speculative and makes assumptions about expenses and changes that can be expected during your retirement years. For instance, it projects the inflationary index and expected investment returns over your expected life span.
Just as with the retirement ratio method, this method assumes that current trends will continue well into the future. Regardless of the method you use, it is always a good idea to plan for the unexpected, suggests T. Rowe Price Investment Services. For instance, the average return on stock market investment instruments is around 7 percent growth per year on average, but there have been years that were more or less.
Also, several eras in American history experienced higher than average inflation. There is no way to predict the future, but to be on the safe side, it is a good idea to take the historical averages and plan for a little padding.
Other Retirement Calculation Methods
Other methods for calculating the amount you need for retirement exist. These include the income method, which is a straight calculation of your current monthly income to determine how much you need. Another method is the direct expense method, which assumes your expenses will remain constant throughout your retirement years. Another method is the savings method, which is a hybrid of these two methods.
Choosing the Right Retirement Calculator
These are only a few of the more popular methods for calculating how much money you will need in retirement. Of course, many factors will affect which one is the most realistic representation of what you can expect in your retirement years. Many retirement calculators assume that you want to keep a similar lifestyle to your current one, but there are many variations and changes that you might want to make that could change how much you actually need.
The best piece of advice is to calculate your best-case and worst-case scenarios using several different retirement calculation methods. This will give you an estimate of the range that you need to consider in your retirement plans. It is always better to plan for a little extra than to come up short when you need it the most.
At the very least, this philosophy will let you make the most of your golden years and enjoy the financial security that you have worked so hard to build.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.