by Paul Merriman
At some point, every investor who is planning to retire must confront his or her financial future. For most people, basic retirement planning can be distilled into 10 numbers.
As I worked with thousands of people over the years, and I saw over and over that when these numbers come into focus, the future starts looking clearer and less mysterious.
As you work to nail down these numbers, I suggest you regard the process as an exercise in discovery. Some items are easy to determine, while others may require some digging and careful thought. I think you will do a much better job if you use a competent financial adviser to help you get the right numbers and see what they mean for you.
One: Your current cost of living. This is the foundation of everything that follows. You could go into great detail on this, but a quick-and-dirty approach may be enough to get the process started: Identify your current gross income and subtract whatever you are saving for the future, including contributions to any IRA and employee retirement accounts. That's your cost of living, including taxes.
Two: The rate of future inflation. You will have to estimate this, of course. We all know that $100 isn't what it used to be, and inflation isn't likely to go away. Since 1926, inflation has been 3%. Over the years, that can do much more damage to your finances than you might think.
Three: The number of years before you will retire. This isn't as simple as it seems. We can't always control when we stop working. And baby boomers increasingly retire in stages. But getting a useful financial snapshot requires a number here. So for this exercise, choose a future date when you want to be financially ready to leave the workforce "cold turkey."
Four: Your inflation-adjusted cost of living in your first year of retirement. While you can crunch the number yourself with a financial calculator, this item can have lots of moving parts.
How will your taxes change? Will you spend more money on travel and hobbies? Less on commuting and clothes but more on health care? Will you move in search of lower housing costs, a better climate or to be closer to your kids? I suggest you use an adviser to help make sure you have not overlooked something important.
Five: The noninvestment retirement income you can count on. Probably this will include Social Security. It might also include a pension or rental income. Don't include interest, dividends and capital gains; they come into play next.
Six: The retirement income you will need from your portfolio. If you have the first five answers, this one requires only simple math. You know how much you'll need in that first year of retirement, and you know how much you can count on. The difference must come from somewhere else, most likely your portfolio.
Seven: The size of the portfolio you'll need when you retire. If your investments are properly balanced between well-diversified stock funds and low-cost bond funds, you should be able to withdraw 4% of your portfolio annually without much risk of running out of money.
Multiply the result you obtained in the previous step by 25. That's how big your portfolio should be on Day 1 of retirement. If this number seems impossibly large, don't panic. There are lots of things you can do about it.
Eight: The current size of your portfolio, excluding real estate and other nonliquid assets. For most pre-retirees, this number will be less than what you will need when you retire. The next items will help you build it up.
Nine: The amount you're saving for retirement every year. You should already know this from the very first calculation. If your annual savings plus your present portfolio will equal the result from Item seven, then you're in fine shape. More likely, these savings alone won't be enough. That's why you need some growth in your portfolio.
Ten: The annual return you need from now until you retire. While you can make this computation with a financial calculator, I suggest you discuss this point with an adviser to make sure you have reached a reasonable result.
The point of this exercise is to get a snapshot of your retirement readiness. I found an online calculator that, while it doesn't cover all the information I have described, will give you a quick idea of whether or not you are on the right track.
Several times I have recommended using a financial adviser to help you through these calculations, and you can do that without establishing a long-term relationship. You can hire one by the hour to check your work and make sure you have an action plan to get you where you want to go.
If you do that, these 10 numbers can change your life.