This has to be one of the most searched questions on Google. That's because we've never retired before, so it's difficult to visualize and estimate what our future living costs will be over a finite but unknown time span.
The way most people approach this challenge is to save as much as possible or save enough to support a percentage of pre-retirement income. Both approaches have their drawbacks. Saving for the sake of saving can at best lead to over-saving and at worst under-saving. And basing future spending on a percentage of pre-retirement income oversimplifies the need. The common problem with these approaches is they focus more on saving for retirement and less on spending in retirement. That's because it's difficult to know how much to save for retirement when you don't know how much you will need and want to spend in retirement.
One way to begin knowing how much to save is to simplify the issue: What do you expect your essential monthly expenses to be in retirement, and what type of monthly income will you have? Doing that will give you a more realistic view of whether the money you’ve saved will last. Begin with an understanding of your essential expenses, layer in the goals, and account for the risks you'll face in retirement. From here, you'll have a better sense of the savings needed to meet the challenges and opportunities that retirement presents.
We've put together a simple 4-step framework to help you determine how much you really need to save for retirement.
1: Determine your essential expenses
Start with your essential monthly expenses, things like your mortgage or rent, utilities, groceries, car payment, and medical co-pays. You’ll feel more secure and less stressed knowing you’ll be able to cover your essential expenses.
2: Determine your goals and risks
Retirement is more than paying the bills. It's also an opportunity to pursue the things you didn't have time to do while working. Goals are the reward for all the years of working, saving, and sacrificing. Tally up the costs for all the things you want to do that give meaning and enjoyment to life.
Next, think about all the things that could stand in the way of your goals. They include the risks of living longer than expected, the rising cost of living, unpredictable medical costs, and market downturns.
Thinking through your goals and risks will give you a clear idea of how much the opportunities and challenges will cost.
3: Determine your expected income
You've determined your essential monthly expenses, goals, and risks, now it's time to identify how you'll pay them. These are your expected income source and include Social Security and pension payments, IRAs, 401(k)s, investments, and annuities. Once you add up your income sources, you'll have a better sense of how you'll pay for retirement.
4: Determine your income gap
You'll begin to get an idea if expected income will cover expected expenses, goals, and risks. If it doesn’t you may need to make some changes, such as increasing savings, finding a better way of converting savings to income, reducing planned expenses, or pushing back the retirement date.
It’s impossible to know how much to save for retirement unless you know how much you’ll need to spend in retirement. A good starting point is to focus first on essential expenses, goals, and risks you expect to have in retirement. From there, review expected income sources to determine if there's a gap between expenses and income, and explore ways to bridge the gap. Calculating how much to save for retirement will always be a challenge, but following a framework such as this will help you feel more secure and less stressed knowing you’ll have enough saved to fund retirement.