A Simple Way to Determine Retirement Readiness
February 25, 2010 by Mr. GoTo
Filed under Planning Tools
Am I financially able to retire? Isn’t that the number one question being asked by older baby boomers when thinking about retirement? It has to be in the top five. There are dozens of ways and places to find answers to the retirement readiness question.
First, when I say that my suggested retirement readiness assessment method is “simple”, I don’t necessarily mean “quick.” The first step may require a little effort on your part. So here it is:
Step 1: Create a Retirement Spending Plan
All this means is knowing with some degree of accuracy how much money you will need to spend each year when you are retired. You may already have done that math. If not, spend 30 -60 minutes creating a retirement spending plan. Use a budget spreadsheet. If you don’t have one, you can download a free budget spreadsheet from Google Docs. Be as accurate as you can without getting buried in details and pennies. Don’t worry about inflation at this step.
When you are done creating your retirement spending plan, make note of the total yearly spending number. You will need that later.
Estimated time to complete this step: 30-60 minutes.
Step 2: Estimate Your Annual Social Security Income
Find the paper copy of your annual Social Security retirement statement or use the online benefit estimator. Determine what your monthly benefit will be on the date that you retire. Multiply by twelve to obtain a yearly total. Write that number down.
Estimated time to complete this step: 5-10 minutes
Step 3: Total Your Retirement Nest Egg
In this step you add up the present dollar value of all of your investments and other assets that you can use for providing retirement income. These can include CDs, bonds, stocks, mutual funds, 401(k) and IRA account balances, etc. As one example of “other assets”, if you will be downsizing into a less expensive home, this may provide cash when you liquidate your equity. Write the total calculated number down, as you will use it in Step 4.
Estimated time to complete this step: 15 minutes.
Step 4: Annuitize Your Retirement Nest Egg
This is where, for sake of simplicity, we make an assumption: You will use all of your retirement nest egg to purchase an inflation-adjusted, immediate annuity. You won’t actually do this when you retire (although you could) but it gives you some idea of how much retirement income your nest egg can provide, if properly invested. Note that I specifically mentioned annuities that provide inflation adjusted income. This is important because you want your spending power to remain relatively steady throughout your retired life. Social Security has cost-of-living increases. You want your hypothetical income from your retirement nest egg to do the same.
To determine how much retirement income you can expect if you annuitize your retirement nest egg, use an annuity calculator. Vanguard has one of the best here. To make it simple, request the annual income number for a single life with no cancellation option. Be sure to check the “Fixed Income with Inflation Adjustments” box. Write down the annual income number that is generated from the calculator, using the lump sum dollar amount you determined in Step 3.
Estimated time to complete this step: 5-10 minutes
Step 5: Add Income and Compare to Spending
This step is simple arithmetic. Add the annual Social Security retirement benefit determined in Step 2 to the annual annuity income determined in Step 4. This represents your hypothetical annual retirement income that you can expect for your lifetime, adjusted for inflation.
Now compare that total income number with your annual retirement spending that you determined in Step 1. If the income number exceeds the spending number, you may be financially prepared to retire. If the spending number is larger than the income number, you may have some work to do.
Estimated time to complete this step: 5 minutes
Why This Simple Method Works
The two biggest financial concerns for retirees are outliving their income and inflation. This method takes these concerns into account by using income sources that you generally cannot outlive and that are adjusted for inflation. Because inflation adjustments are built into the income estimates, you can use existing spending levels for your spending plan.
Is this method perfect? No it’s not. For example, it may not take into account severe health problems requiring long term care or unusual expenses not accounted for in your spending plan. The correlation between annuity income and investment income from your retirement nest egg is not exact. But this method is simple, is logical, and is better than not knowing what to expect in the way of sustainable retirement income. It can certainly help add some realism to the “am I ready to retire” question.
Give it a try. Let me know what you think.
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