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How Much Retirement Income Will I Want?
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THE SCENARIO
Looking ahead to retirement can be a real challenge. You have to do a lot of guessing: how much can I afford to save every month, what kind of return on my savings can I get, how long will it be until I need the money? There are a lot of assumptions involved so it's hard to be totally confident in the results.
What's more, most of the analyses we tend to do ignore or be confused by the effect of inflation. Sure, my $1 million retirement nest egg
sounds like a lot of money, but if it's 40 years in the future, what will that be worth in today's dollars?
To address this, I like to consider how much income I'll want, and then move on to figuring out what kind of account balance I'll need in order to support that, and then work backward from there to figuring out what I need to do starting today in order to retire the way I want. This post, however, is focused on part 1 of that process: how much income will I want to live off of when I retire?
It's tempting to assume that when I retire, my house will be paid off and my expenses will go down. But while my house
may be paid off, expenses tend to expand to fill (and exceed) the available resources, so I'm going to assume that I'll need as much money after I retire as I do today, with a little bit of pad.
The question: If I live on $6,500 per month today, I expect to have the same level of expenses when I retire (adjusted for inflation), I want to retire in 25 years, and inflation ends up averaging 4.5%* per year between now and then, then what monthly retirement income will I need when I retire? Assume that inflation is uniform and compounds monthly.
* Over the past 30+ years, inflation has been lower than this - somewhere between 3% and 3.5%. However, if I guess high on what future inflation will be, then the worst that happens is that I end up with
too much buying power, which is preferable to the alternative.
THE SOLUTION
This one is pretty simple.
First things first, make sure the calculator is using 12 Payments per Year.
N: 300 (I plan to retire in 25 years, which is 25 x 12 = 300 months)
I/YR: 4.5 (The problem assumes inflation will be 4.5% per year on average)
PV: -6,500 (I'm trying to find the inflation-adjusted value of $6,500 today)
PMT: 0 (Inflation calculations don't tend to have money flowing in or out in the interim)
FV: (This is what I'm trying to find)
To support the same level of expenses that $6,500 does today, I'll need $19,979.33 every month starting in 25 years.
Trying to predict the future is challenging, as it takes a lot of assumptions. However, if your assumptions are relatively conservative (i.e. if you made an error, it works out in your favor), that leaves you some margin for error.
What do you think? Does $20k per month sound like a large amount to live on? In today's dollars, it sure does to me (it's three times what I live on now). But does it make sense that I have to figure out what the money will be worth in the future if I want to make sure I'll have enough to live on? Why or why not? Have I missed anything here? Let us know in the comments!
