The real nest-egg calculation

You can't figure out how much you need to save for retirement until you estimate how much you'll receive from Social Security and pensions.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: When I read about the amount of money required at retirement age to fund a desired lifestyle ($1 million, $1.5 million, etc.), I always wonder what counts toward that amount. Like many people, my wife and I will have a mix of investments as well as several small pensions and Social Security.

Should all these be counted? If so, how would the annual incomes be converted to lump sums? - David Black, Falcon Heights, Minn.

For what you want to do - that is, figure out how much you must save on your own to support yourself in retirement - you do need to have a decent estimate of how much Social Security and pension income you'll receive. You find that out by contacting the human resources departments of your various employers providing pensions and by checking out one of the Social Security Administration's online calculators.

But you don't have to convert those monthly payments into a lump sum. Nor do you want to. I think the best way to explain why is to just go through the process of how you estimate how much you should have tucked away in your 401(k)s, IRAs and other retirement accounts by the time you retire.

Start by estimating how much annual income you'll need to live on once you retire. If you're still a decade or longer away from retirement, you can guesstimate that figure by assuming you'll require a certain percentage of your pre-retirement income.

The rule of thumb is to assume you'll need 70 percent or so, but to give yourself a decent margin of safety, I think you probably ought to shoot higher, more like 85 percent or 90 percent, even more if you plan to do a lot of traveling and live large after you retire.

Okay, so for argument's sake, let's make a few assumptions. We'll say you need annual income of $75,000 when you retire. (I'm assuming you'll increase that figure by the inflation rate each year so that your purchasing power remains constant over time.) And let's also assume that you'll receive annual Social Security payments of $15,000 and yearly pension payments of $10,000.

So if you subtract your $25,000 in combined Social Security and pension payments from the $75,000 income you need, that means you must fund the difference, or $50,000 a year, from your investments.

The question then becomes, how large a nest egg do you need at retirement so that you can draw $50,000 a year (increased annually for inflation) from it for the rest of your life?

The rule of thumb in this case is that you need about $25 in assets for each $1 you need in inflation-adjusted income.

In this example, that means at retirement time you must have 25 times $50,000 socked way, or $1,250,000.

That figure would have to be larger if you were getting less from Social Security or pensions. If your Social Security benefit were just $10,000 a year, for example, then you would need your investments to generate $55,000 of income a year (your $75,000 total need minus $10,000 in Social Security and $10,000 in pension income), which would require a nest egg of $1,375,000 (25 times $65,000).

So the amount you expect to receive in Social Security and pensions does affect the size of the nest egg you should shoot for. But you don't have to convert your Social Security and pension payments to a lump sum to arrive at your estimate.

Keep in mind that what I've just described is the back-of-the-envelope way of estimating how much money you need. In fact, arriving at a more accurate figure is a bit more complicated.

For example, while Social Security payments increase with inflation each year, most corporate pension payments do not. So, all other things being equal, you would actually need a somewhat larger nest egg than I've estimated to compensate for the fact that over time your pension payments would lose purchasing power.

There are other factors you must consider. Your investment strategy will have an impact on how much money you need to accumulate for retirement, as well the performance of the investment markets and the length of time you'll spend in retirement.

The "$25 in assets per $1 of income" rule I mentioned earlier assumes you're going to spend 30 or more years in retirement. If you retire very late in life, you might be able to get by with a smaller nest egg. Conversely, if you retire early, at 50, say, you probably need a larger one.

And, of course, this estimate depends on how much personal "wiggle room" you have in your lifestyle. For example, if you can easily ratchet back your spending when the investment markets decline and your portfolio's value takes a hit, then maybe you can get by with a smaller pool of savings.

All these complications are reasons why you're better off making this sort of estimate with a sophisticated software program or calculator that can factor in these subtleties and also show you how you can improve your chances of achieving a secure retirement by making changes such as saving more, investing differently or retiring a few years later.

The Retirement Planner tool on our site is one such calculator. Fidelity's new myPlan Snapshot, which takes less than five minutes, can also give you a quick assessment of whether you're on track and what you can do to improve your prospects. For a more detailed analysis, though, you might want to try Fidelity's myPlan Retirement Quick Check, which you'll be given the option of using once you get the results from the myPlan Snapshot.

If you're close to retirement or already retired, you can get an estimate of how long your savings are likely to last by going to T. Rowe Price's Retirement Income Calculator.

Or, if you're not comfortable doing this sort of number crunching on your own even with the help of an online calculator, you can always go to a financial planner.

After all, the last thing you want is to retire believing you're all set, only to find out later on that your nest egg isn't going to last nearly as long as you will.

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