When it comes to budgeting for retirement, your goal should be to calculate how much money you’ll need each year during retirement. For most people, that means figuring out how much money they think they’ll need during the first year of retirement, and then making a small percentage adjustment to that amount each preceding year.
After all, this is an important calculation. Nearly all retirement calculators rely on this figure to estimate how much money you’ll need to save for retirement. So getting it wrong could be very costly during your precious retirement years. Underestimating costs could mean living in fear of running out of money, and overestimating could mean that you don’t get to retire as early as you could have.
There are many different methods that people use to arrive at a retirement budget figure. According to a recent study from the Employee Benefit Research Institute, workers used the following methods to determine how much they needed to budget for living expenses during retirement:
- Guess the amount – 42% of people just guess how much they will need each year during retirement
- Use an adviser – 21%
- Make their own estimate – 21%
- Read or hear about how much they need – 9%
- Use an online retirement calculator – 7%
- Base their expenses on current lifestyle and expenses – 5%
- Fill out a retirement worksheet – 5%
Look at the list of ways that people determined this figure. Do you see anything that looks funny? To me, it seems ludicrous that only five percent of people base their retirement income on their current lifestyle! In fact, only a about 12% of people even use any type of calculator or worksheet to help them figure out what they’ll need.
Even more suprising is that the vast majority of people actually guess how much money they’ll need!
If you’re trying to estimate your annual income needs during retirement, we suggest you don’t just guess, but that you use some type of sound logic to help you estimate it. We recommend looking at a detailed budget of where you are now and then modifying it to account for your retirement living style. Here are some steps we would take:
Start With Today’s Budget
If you don’t have a household budget put together yet, you can estimate one for this purpose. Make sure you get a good estimate of all the major parts of your day to day living expenses so that it is a fairly complete picture. Your retirement budget will be based on this so make sure it is as accurate as you can make it. Run some checks on the numbers. Add up all of your personal or family income and subtract the expenses. Check that the amount remaining is actually the amount you had left over. If it’s way off, try to fix it. When you’re comfortable with your current budget, move on to the next step.
Remove Expenses That You Won’t Need During Retirement
Now it’s time to remove the expenses that you won’t have during retirement. For example, if your mortgage is going to be paid off, you can exclude it from your retirement budget. If you will get by with just one car, you can remove that expense. If you are spending on your children now or saving for their education, you can remove that expense. I’m sure you get where we’re going with this. Go through each category and eliminate the expenses that you won’t be needing during retirement.
Add In These Retirement Expenses
Now it’s time to add in the retirement expenses. Most people think that traveling will be their biggest retirement expense, but really the biggest expenses will likely be health care. While you can probably count on medicare to cover a good portion of most health care expenses, many people will not have coverage for any long term care or hospice type care. Some people never need these types of care, but for planning purposes, you should investigate the potential cost and add it to your retirement expense. Or, at least look into the cost of long term care insurance and then include the premium for that in your budget. Also, be sure and include any other costs that you plan to do when retired. Whether its buying a boat or getting a condo someplace warm or near your children.
Adjust For Inflation
Now that your retirement budget is almost in place, you’ll want to adjust the annual expenses for inflation. If you are a few years away from retirement then you don’t need to do this. If you are a long way from retirement, this is very important. Assume an overall inflation rate of about 3% if you want to stay in line with historical rates. However, health care costs have been rising at double the rate of inflation, so you should use a higher rate for these expenses. Use inflation rates to see what your budget will be in future dollars and that should be the figure that you use to calculate how much money you’ll actually need to save for retirement.