Liz Pulliam Weston

The Basics

Your magic number for retirement

A new calculator reduces all your retirement planning to a single figure. It's a handy and useful guide, but can you handle the answer?

By Liz Pulliam Weston

Roger Ibbotson has a problem with most retirement calculators. They're either too simple or too complex, and sometimes they're both at the same time.

Roger Ibbotson

Roger Ibbotson

That's a serious issue, says Ibbotson, a finance professor at the Yale School of Management, because people increasingly are in charge of investing for their own retirements. Yet they're getting conflicting and sometimes misleading answers to the biggest question of all: How much should I save?

Here's what Ibbotson, who founded a leading financial research firm, Ibbotson Associates, says is wrong with many retirement calculators available today:

They use static return assumptions. Assuming your investments will return 8%, 9% or any other static figure is old school. Financial planners today typically use Monte Carlo simulations, a statistical technique that factors in long-term performance to calculate thousands of possible results for a given portfolio. With these simulations, you can learn your probability of success -- the chances that your portfolio and your financial plan will provide enough money for retirement.

They require too much knowledge -- or guessing -- from consumers. In addition to asking you to guess your investment results, you're usually asked to answer other tough questions: When will you retire? How long will you live after that? How much will you get from Social Security? What will your home be worth? How much, if anything, will you inherit?

They overestimate retirement spending. The default assumption is that you'll need 70% to 80% of your current gross income to retire. Although some financial planners argue that replacement rate is too low, others have more recently contended that such percentages may be too high because they don't reflect the fact that many people's spending drops as they age.

A better mousetrap

Ibbotson thought there was a better way to determine the ideal savings rate, a method that employed the financial-planning world's sophisticated techniques but was simple enough that any consumer could use it.

So with the help of two Ph.D. researchers at Ibbotson Associates and two financial planners from Kreitler Associates in New Haven, Conn., Ibbotson built what he thinks is a better mousetrap. The result, which Ibbotson dubbed the "National Savings Rate Guidelines for Individuals" (.pdf file), debuted in 2007 in the Journal of Financial Planning.

With the charts the researchers created, individuals can quickly look up their ideal savings rates based on their ages, incomes and accumulated savings for retirement -- in other words, how much they've already saved.

The magic number it produces represents the percentage of your gross income you need to save today to replace 80% of your net income starting at age 65, ensuring, at least theoretically, a comfortable retirement. Ibbotson defines net income as your gross income minus what you're saving for retirement.

A warning here: If you're much over 35 and you haven't already saved a substantial sum for retirement, the suggested savings percentage is going to be scary -- either a little scary or a lot scary, depending on how old you are and how much you've put aside.

(Also, Ibbotson ran a limited number of income scenarios, topping out at $120,000; frankly, if you make a lot more than that, you need to talk to a certified financial planner.)

Please don't panic. Things might not be as dreary as they seem. You may be able to craft a workable retirement plan by:

  • Factoring in other assets, such as an inheritance or the sale of your home.

What Ibbotson's percentages reflect is the importance of an early start if you want to be assured of a comfortable retirement that starts at age 65.

"If you haven't started by age 35 or 40, it's really hard" to save enough to accumulate an adequate nest egg, Ibbotson said. "The longer you wait, the more you have to save" to make up for the delay.

In fact, the percentage of your income you must save if you start at age 45 is typically more than twice what it would have been had you begun at age 25, according to Ibbotson's charts. If you wait until age 55, the percentage is often triple what it would have been had you started 30 years earlier. Someone in their mid-50s who earned $80,000 a year, for example, would have to save more than one-third of their income -- 36.6% -- to accumulate enough to retire at 65.

Fine-tune your magic number

To understand how to use this research in your retirement planning, you should understand the assumptions Ibbotson and his cohorts made, and how you might want to fine-tune the number you get.

Ibbotson's tool includes these points:

It uses a replacement rate of 80% of net income. Net income, as I mentioned earlier, is defined by Ibbotson as your gross income minus what you're saving for retirement. Some financial planners believe this level is far too low and want their clients to shoot for replacing 80% or more of their gross income to ensure an adequate retirement. (Some insist 100% of gross makes more sense for clients who expect to travel extensively or indulge expensive hobbies.)

Other planners, though, say that's way too much because retiree expenses tend to drop precipitously in later years. These planners contend the financial-services industry is encouraging people to over-save and unnecessarily delay retirement. (For details, read "Are you saving too much for retirement?")

My take: 80% of net income is probably enough to ensure a comfortable but not luxurious retirement. If you want to travel a lot or spend more lavishly, you should treat Ibbotson's indicated percentage as the minimum you should save. If, on the other hand, you think you can get by with less, you might use MSN Money's Retirement Planner instead, adjusting the "How much you'll need annually" input to reflect your future budget.

Continued: What about medical care?

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