How Much to Save and Invest for Retirement

Americans are confident they will have comfortable retirements. Seventy percent of Americans age 25 and older told the Retirement Confidence Survey for 2004 they are confident of achieving a comfortable retirement. Yet only 58% were actively saving for retirement, and only 42% ever tried to calculate the amount of money they will need in retirement.

It seems that for many Americans their confidence doesn’t have a strong foundation and might be misplaced.

Any retirement spending estimate is better than none. But for years at Retirement Watch we’ve been researching and developing the best ways to make reliable estimates of retirement spending and savings needs. Most popular methods of projecting retirement needs tend to dramatically understate or overstate retirement spending. You can review the past discussions of this topic in the Cash Watch section of the web site Archive at www.RetirementWatch.com.

Here’s another strategy for estimating retirement spending needs that builds on our past suggestions. Use it to refine your estimates of likely spending and how much capital you will need.

Instead of viewing your retirement spending as one lump sum, divide future spending into different baskets. Regular living expenses can be one basket. Other possible baskets are major purchases and capital expenditures (separate baskets for each major item), financial needs of family members (such as the grandchildren’s education), and charitable gifts. It also makes sense to take major, regular expenditures such as medical care out of living expenses and put them in separate baskets.

Next, decide how much you will spend in a basket and when the expense will be due. Here are some examples.

Suppose you are 10 years from retirement and want to buy a second home without debt at retirement. You figure the home you want will cost about $200,000 at that time.

There are several different ways to determine how much you need to be saving and investing to reach that goal. Let’s say you already have a lot of cash or investment assets. You want to set a portion of that aside and ensure that it will be worth $200,000 in 10 years. To do that, identify a safe investment. A 10-year treasury bond is a good choice. (A 10-year zero coupon bond and a tax-exempt bond are other options.) For our example, we’ll say it will yield about 5%, or 3% after taxes. Using a calculator to compute the net present value formula, you find that you need to invest about $150,000 in 10-year treasury bonds. Hold them to maturity and your goal will be met. If you can net 5% after taxes, only about $123,000 needs to be invested.

If you don’t have the cash available now, decide how much cash you can make available through savings. Then calculate the rate of return needed to meet the goal. Then, turn to the investment markets to determine how much risk you need to take with the investments to achieve that rate of return over the next 10 years.

For example, suppose you have $50,000 available for the house today and can save another $5,000 annually. You will invest a total of $100,000 over the 10 years, so the compounded investment return needs to be high enough to double the amount you invest. My calculator says you need about a 9.4% annual return after taxes to meet the goal.

An 8% investment return gets you only to $180,000, and you need to earn the 8% each year after taxes. An 8% return is aggressive for the next 10 years. You’ll have to take risks such as buying preferred stock or high-yield corporate bonds that yield more than 8%. You also could invest primarily in stocks and hope for a strong market.

Or you could adjust the plan. Either try to save more or change your goals for the house. For example, adding an extra $5,000 of savings to the fund at the start of the first year brings the total to almost $192,000 with an 8% return and no other changes. Leaving the initial investment at $50,000 but increasing the annual savings to $6,000 gets you to almost $195,000 with an 8% return.

You also have to recognize that the risks might be realized while the returns are not. Investment performance below the target means you won’t have the $200,000 available in 10 years.

Let’s take a look at how medical expenses can be handled under this approach. One recent estimate is that the average retiree will spend about $90,000 on medical expenses after age 65. That includes insurance premiums and all the expenses not covered by insurance or Medicare. It does not include any long-term care. It also is an average. Many will spend more than that; many less.

The difference with this type of expense is that it is not a lump sum payment. The lifetime expense breaks down to about $6,000 annually, but the amount incurred each year will vary. You will have little advance notice of major expenses.

You could try to accumulate by the start of retirement either a $90,000 fund for medical expenses or a $120,000 fund that would pay income of $6,000 annually at a 5% yield. Either approach would ensure that you have enough money for the medical expenses. But the reserve you create would be greater than most people will require.

A more realistic approach is to estimate the length of your retirement and determine how much it would cost to buy an annuity paying $6,000 annually for that term of years. You don’t actually have to buy the annuity. But the exercise shows you how much to save to meet the expense assuming you earn today’s rates of return for conservative investments. At www.AnnuityShopper.com, a lifetime annuity for a 65-year-old man requires on average a deposit of $76,500. To guarantee payments for at least 15 years, the cost is $82,200.

If you cannot save that much solely for medical expenses, then you know that adjustments are needed. For example, you might have to take more investment risk to seek higher returns on the fund.

You can do this type of analysis for all or most of your expenses. Separate the expenses into baskets and estimate how much you need to save, using the return of a safe treasury bond or annuity as the benchmark. That shows the maximum amount you’ll need to save. It also makes it easier to know how to modify the plan by changing some goals or seeking higher investment returns for some of the assets. This approach is a more flexible and workable way to plan retirement than viewing retirement spending as one lump sum.