Many of the old rules for retirement planning are under siege. Determining how much money you'll need for a comfortable retirement—and how to save it—has never been an easy task. Retirement planning experts offer a variety of conflicting ideas on just how to arrive at that magical figure. Now, the gut-wrenching changes in today's volatile economy are making that job tougher than ever. Millions of employees and business owners who thought they were on the path to a financially secure retirement are discovering that their goals may be beyond reach.
Longer lifespans and the ongoing pressures of inflation have combined to complicate one of life's toughest challenges: how to make your money last longer than you do. Whether your planned retirement is years away or just around the corner, inflation is destined to have a major impact on your future economic well-being. If you ignore it, you do so at your own peril.
Inflation Never Lets Up
As the chart below shows, inflation can vary wildly over the years. Regardless of the rate, it relentlessly exerts its influence.
Even that seemingly harmless inflation rate of recent years will take a significant toll over time. After 10 years of 2 percent inflation, that dollar bill now in your pocket will be worth only 82 cents.
Effect on Your Retirement
Here's an example of how inflation affects your life right now: If you paid $60 for a week's groceries in 1985, you're paying about $109.67 for those same items today. Beating Inflation's effects
If you paid $18,000 for a new car in 1985, it will cost you approximately $31,944 to replace it with a similar 2007 model. Ten years from now, a comparable new car will cost you about $40,891 (assuming a modest 2.5 percent inflation rate).
Calculating inflation's effects over a period of two or more years can be dauntingly complex. That's why it's difficult to make simple dollar-to-dollar comparisons from one year to another. If you'd like an easy way to gauge inflation's effects on some of your personal expenses, log on to www.westegg.com/inflation. This easy-to-use calculator adjusts any given amount of money for inflation, according to the Consumer Price Index, from 1800 to 2006.
How Much Income Will You Need in Retirement?
You've probably read several variations on how much income you'll need during your retirement. Many financial planners estimate that you will need 80 percent of your pre-retirement income to maintain your current lifestyle once you stop working. If your earnings are, say, $60,000 per year just before you retire, you will need $48,000; if your annual income is $120,000, you'll need $96,000 per year to retire in the style to which you have become accustomed, according to this popular school of thought.
However, Walt Woerheide, Ph.D.,vice president of academic affairs, the American College, Bryn Mawr, PA, believes that most people experience a significant drop in expenses when they retire. "Chances are your mortgage will be paid off, you'll no longer need to put aside money for savings or college tuition, and you'll have the time to do chores that you may have been paying other people to do," he says.
But according to Carl J. Kunhardt, a Certified Financial Planner (CFP) in Dallas, this isn't true. "We're finding that clients are spending essentially the same in retirement as before," says Kunhardt. "It's what they are spending on that changes in retirement."
So, obviously, experts don't agree on a single model for estimating financial needs in retirement. More problematic, perhaps, is that some of the popular formulas fail to consider inflation.
The Charles Schwab brokerage recently published a retirement planning rule-of-thumb that takes clear notice of inflation's effects. It suggests that you will need $230,000 in retirement savings in today's dollars to get $1,000 in monthly income during retirement. For example, if you want to add $2,000 per month to your Social Security income, you would need $460,000 in retirement savings and investments—in today's dollars.
The key phrase in the Schwab formula is "in today's dollars." If, say, your retirement is 10 years off, you will need to increase the $460,000 mentioned above to allow for the effects of 10 years' inflation.
It's impossible to predict the exact inflation rate in advance; all you can do is estimate. Even if you assume that today's inflation rate will remain the same over the next 10 years, that $460,000 in today's dollars will equal about $555,264 in 2017.
Since the current low rate of inflation may not continue for much longer, you should adjust your estimate of required retirement income to compensate for the latest rates.
How to Compensate for Inflation's Impact
Financial consultant Ingrid K. Lamb, CPA, of Chesapeake Beach, MD, points out that Social Security and some private pensions are adjusted to help counteract the harmful effects of inflation. Still, retirees who depend on investments for a significant part of their income may find that's not enough. "One way of compensating for inflation," she says, "is to invest part of your portfolio in dividend-paying stocks that have a long payment history and a record of steady dividend increases."
Maury Randall, professor of finance and department chair at Rider University in Lawrenceville, NJ, agrees that every retirement portfolio should contain some stocks as a hedge against inflation. "Another method of protecting yourself is investment in inflation-indexed treasury securities (known as TIPS). These treasury bonds provide a return based on the current rate of inflation, he says. "So, when inflation rises, you'll get a higher interest rate." You can get more information on TIPS from any broker or at TreasuryDirect, the U.S. Treasury's web site, www.savingsbonds.gov.
Regardless of the method you use for retirement planning, you must take inflation into account. "If you hope to enjoy a comfortable retirement, you'll have to arrange for it yourself," says Kunhardt. "No one else is going to worry about your financial health in retirement. If you don't take care of it yourself, it won't happen."
The way to make it happen, says G. Mike Crawford, CFP, CEO of Lifeplan Financial Group, Dayton, OH, is to maintain a detailed financial plan for your retirement. "Without a road map, it's difficult, if not impossible, to see where you've been and where you're heading," says Crawford.
Understandably, he believes that a retirement plan prepared by a CFP is the best choice for most people. Yet Crawford recognizes that many people prefer to do their own planning. "That's fine," he says, "for those who have a good feel for personal finance and how to handle money. Whether you call on a financial professional or prepare it yourself, it's important that your plan stay active and flexible." — William J. Lynott