The first step in any retirementplan is estimatingwhat will be your monthlyor annual expenses duringretirement. Most of ustend to underestimate it for various reasons.But chances are that most of uswill be in good health, at least for thefirst 10 or 15 years of retirement, andwill likely eat out more, travel more, etc,all of which will increase expenses.
The following are three suggestionsfor making realistic estimates:
•Plan in today's dollars. Becauseof inflation, the value or buying powerof the dollar will keep declining. Forexample, if you are 20 years from retirementand inflation averages 3% per yearbetween now and then, a dollar thenwill have the buying power of only 54cents today. We cannot make this adjustmentmentally.
So the best approach is to first estimatewhat your expenses will be if youretire tomorrow—estimate the expensesin today's dollars, and then adjust themfor inflation assuming an appropriateaverage inflation rate until retirement.Your plan should also account for theeffect of inflation during retirement. Thismeans that if you estimate expenses of$100,000 per year in the first year ofretirement and 3% inflation per year,then in the second year of retirement youwill need $103,000, and so on.
Fortunately online retirement planningsoftware can do these adjustmentseasily. But you still have to provide theinflation assumptions. Remember thatthe historical average inflation rate of3% per year you hear about is the ratefor the average basket of goods and servicesfor the average consumer. Yourfinancial planner may be able to provideyou better estimates of the rate of inflationfor the types of goods and serviceson which you may spend proportionallymore of your income relative to the averageconsumer (eg, health care and luxurygoods).
•Plan in two buckets. It is best toestimate your retirement expenses intwo buckets or pieces: one for essentialexpenses and one for discretionaryexpenses. The essential expenses numbershould cover what you consider tobe a moderate standard of living. Andthe discretionary expenses shouldcover your wish list, which can betrimmed if necessary.
You should then invest the savingsneeded to cover the essential expensesreasonably conservatively (especiallyafter retirement) and the savings meantto cover the discretionary expensesmore aggressively. That way, if theaggressive investments do not workout well, you will only need to trim afew luxuries out of retirement but notthe essential expenses.
•Remember taxes. You will, ofcourse, get to spend only what you haveleft after paying taxes. Your tax situationafter retirement will get complicated. Onsome income in taxable accounts and onwithdrawals from retirement plans (eg,from your 401[k] plan), you will have topay ordinary income taxes. Fortunately,as a retiree you will pay taxes at thelower capital gains tax rate on any securitiesyou sell in taxable accounts. Andon Roth IRA-type accounts, no taxeswill be due on withdrawals. Then thereis the complication of minimumrequired distribution after the age of70 1/2. Finally, there is the uncertainty ofchanges in the tax laws over the years.
If you are far from retirement, it willnot pay to try to make the tax estimatesin detail. Base your estimates on an averagetax rate in the range of 20% to 30%(taking into consideration state taxes).You will need to do a more detailedanalysis when you get, say, within 5 to10 years of retirement. Online retirementplanning software can handle thisonce you provide estimated tax rates.
No matter how hard you try, yourestimates are never going to be precise.Surprises will definitely keep comingup. Aim for only broad reasonableestimates, especially until you get within10 years of retirement, save as muchas you can, and invest wisely, but nottoo conservatively.
Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.