NEW YORK (CNNfn) - Not long ago, retirement was so simple. Most people retired at 65 and relied on their company pensions and Social Security checks for a comfortable monthly income.
But baby boomers will live longer than any previous generation, and they're more accustomed to luxury lifestyles.
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Today's retirees are living longer and expecting more. | |
This, combined with the precarious state of Social Security and the evolution of 401(k)s that puts the burden on the individual to save, could leave many baby boomers and other future retirees in a nightmarish situation – going broke in retirement.
"You really have to plan," said Tom Murphy of Unifi Network, the benefits consulting arm of PriceWaterhouseCoopers. "It's never too early to start thinking about retirement."
How long will you live?
An important – if uncomfortable – first step in retirement planning is estimating how long you're going to live.
According to a 2001 study by the Social Security Administration, an average 65-year-old man is expected to live to about 81, while a 65-year-old woman is expected to live to about 85.
There are many life-expectancy tools available on the Web, such as the Living to 100 Life Expectancy Calculator or Northwestern Mutual's Longevity Game.
But be careful not to take the number you come up with as gospel, especially if you're younger than 65. Medical advances in coming years could add decades to your life.
Dallas Salisbury, president of the non-profit Employee Benefit Research Institute (EBRI), recommends adding 10 years to your life expectancy when planning for retirement.
"I completed the (Longevity Game) last week and was told that I should expect to live to 93," Salisbury told a Department of Labor retirement advisory board in April, "so I assume 103 in my retirement and savings decisions."
Other experts point out that your life span might be much shorter than you expect, so you might plan to spend more earlier, to get the most out of life.
"Not many people are going to have a 30-year time horizon," said Andy Wrobel, senior vice president in Fidelity Investment's retail retirement marketing division. "We don't want people missing out on things they want to do."
How much will you need?
The next, possibly more painful, step in the planning process is figuring out how much money you'll need in retirement.
Keeping track of what you're spending now will give you a good idea of how much you'll need in retirement, since most of your current expenses will stay the same, but other expenses – especially health care and leisure activities – could rise dramatically.
Many financial pros say you'll need 70 percent of your pre-retirement income after you stop working. If you like to live lavishly or want to travel, you may need more. If you plan to scale back your lifestyle, you could get by on less.
"What are you going to do tomorrow?" Wrobel said he asks his clients. "Is that more or less expensive than what you're doing today? It's important to understand what you're doing today."
Dallas Salisbury of the EBRI recommended people use software to track spending and set a budget.
"For the majority of Americans, this will be a tremendous amount of work, as most have never done a budget or documented annual income flows and spending," Salisbury told the Labor Department.
What are your income sources?
The next step will be to track your income sources in retirement.
According to a study by the American Association of Retired Persons (AARP), about 40 percent of a retiree's income comes from Social Security. As you get older, your reliance on your Social Security check will increase. By other estimates, Social Security will replace only about 30 percent of your income.
The Social Security trust fund will start running out of money as soon as 2015 and run dry by 2038. President Bush has appointed a commission to determine how to save the program.
"(Social Security) was not designed to provide an adequate income, and it does not," Salisbury said. "Yet, for a majority of today's workers it will play the same dominant role unless they take action and change their behavior."
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Today's retirees must learn to rely less on Social Security income. | |
That means building other sources of income. In the past, most workers relied on a company pension. Now, most companies offer 401(k)s or similar plans where the employee has to decide how much to save and where to invest.
"In the past, the mindset (of employers) was, 'Come to work for us, and we'll take care of you,'" said Murphy, of Unifi Network. "Now they're looking at the employee and saying, 'You have to help, and we'll give you the tools.'
"You have to really educate yourself," Murphy said. "It doesn't have to be rocket science, but people need to start thinking about it as soon as they're hired."
With a traditional pension, it will be easy to find out how much money you'll get every month in retirement; just ask your human resources representative for a statement. In most cases you can take a lump sum where you roll the money into an IRA or take regular payments.
While in many cases you can leave 401(k) money in the plan when you retire, some financial planners recommend you move your money into a Rollover IRA because chances are you'll have more investing choices and more control over distributions.
When inflation is the enemy
Another factor to consider is inflation. John Begley, a financial analyst with T. Rowe Price, offered the following scenario to show how inflation eats away at the value of your retirement account.
Let's say a worker starts saving $10,000 a year in her 401(k) when she turns 30. She wants to retire at 65 and live on $80,000 a year.
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 INFLATION IS THE ENEMY
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Assuming a 4% rate of inflation, an $80,000 lifestyle will be very expensive in the year 2046.
$80,000 in the year 2001 =
$175,290 in the year 2021 =
$467,294 in the year 2046
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Assuming an 8 percent rate of return before retirement, her nest egg will grow to $1,861,021 by the time she's 65.
That may sound like a comfortable nest egg, but if you factor in a 4 percent rate of inflation, her $80,000-a-year lifestyle will actually cost her $175,290 when she retires at 65 in 2021. And by 2046, when she's 90, that same $80,000 lifestyle will cost $467,294.
So the $1.9 million won't be nearly enough, Begley said. The worker will actually need $3,267,255.
When retirement isn't really retirement
Obviously, you could be in for an unpleasant surprise when you start thinking about what you'll need for retirement.
"The vast majority (of people), if they have been realistic, will see a projected budget that says expected retirement income is not going to cover desired retirement expenses," Salisbury said.
Most experts agree that, in order to ensure you will outlast your savings, you should withdraw no more than 3 to 5 percent of your savings a year.
Thus, if you have a million dollars in savings, you would be withdrawing only $30,000 to $50,000 a year for living expenses -- which might put a cramp in your lifestyle.
For that reason, many retirees are supplementing their income with part-time work.
"We have added another leg to our planning process," said Fidelity's Andy Wrobel. "It's not just assets and Social Security and pensions and health care any more. It's also a part-time work component."
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President Bush recently signed legislation that will allow workers to increase the amount of their annual contributions to their retirement plans. The law raises the savings limits to $15,000 from $10,500 for 401(k)s and to $5,000 from $2,000 for IRAs. It also includes a "catch-up" provision for people who haven't gotten started saving.
The law could offer a lot of help to soon-to-be retirees who find themselves short of the cash.
Finally, all experts agree that this will be one of the most important financial decisions you will make. Do your homework and start planning early.
"Bottom line: You are responsible for your own retirement funding," said Brian S. Orol, certified financial planner and principal of Strategic Financial Planning Group in Raleigh, N.C. 
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