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What's your magic number?
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.
It doesn't include post-retirement medical care. This is a significant omission because various studies show out-of-pocket costs are soaring despite Medicare coverage, which kicks in when you're 65. Fidelity Investments estimated this year that a couple retiring in 2008 without retiree health-care benefits would need $225,000 for medical costs during the remainder of their lives.
This is another reason to kick up your savings a percentage point or two. One easy way to figure out how much: Use the MSN Money Retirement Planner and add $10,000 to the amount you expect to need annually in retirement.
It uses immediate annuities as a proxy for the sum you'll need. I think this is a pretty brilliant solution to the issue of life expectancy. Rather than guess how long people might live, or ask them to guess, Ibbotson turned to the experts. Insurance companies that sell immediate annuities, which give people a lifelong stream of income in exchange for a lump-sum payment, are experts at managing the life-expectancy risk of large groups of people.
To figure out how much you'd need at age 65, the researchers looked at the cost of an inflation-indexed immediate annuity with a lifetime payout that would replace 80% of your net income. The main problem with this approach is that the size of the checks you get depends on prevailing interest rates when you buy your immediate annuity, and interest rates have been pretty low lately. If rates rise substantially, you'd get more bang for your investment buck and may not need to save as much.
There's no way to know in advance what interest rates may be like when you retire; just know that your nest egg may not need to be as big as Ibbotson indicates.
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It assumes Social Security won't change. I think this is a fair assumption if you're in the lower-earning brackets, say $40,000 and below, since Congress is unlikely to trim benefits for the lowest-income workers who rely on Social Security the most. But the more you earn and the younger you are, the less you should expect from Social Security.
Ibbotson's approach doesn't allow you to adjust this input, so you might want to use MSN Money's Retirement Planner if you want to reduce or eliminate your expected Social Security benefits from your calculations.
It assumes you'll get market returns. The charts used Monte Carlo simulations to come up with savings rates and nest eggs that have a 90% probability of success, meaning you'd have enough to live on without significant risk of running out of cash. But this approach assumes you'll at least match the market benchmarks, and most individuals don't.
Even if your portfolio is entirely made up of index funds, you're still paying at least some fees, however minimal, that ensure you'll underperform the market. If you trade frequently or use investments with sales loads or high annual fees, you're likely to fall even further behind. This is yet another reason to save at least 1% more than the indicated percentage (and to keep your investment expenses as low as possible).
Video on MSN Money
Jubak on the retirement crisisThe U.S. housing bust has created an economic slowdown, a home-building depression and a credit crunch. But no one is talking about the retirement crisis, says MSN Money’s Jim Jubak -- even though soon-to-retire boomers have recently lost a whopping $2 trillion in home equity.
It assumes you won't inherit money, sell your house or use a reverse mortgage. If you think you may rely on any of these sources of income, you might want add those amounts to your nest egg in the Magic Number Calculator, check out a more complex retirement planner, such as the one included in Microsoft Money personal-finance software, or consult with a fee-only financial planner. (Microsoft is the publisher of MSN Money.)
In short, Ibbotson's guidelines are not the be-all and end-all of retirement calculations. But they're an excellent tool for people who are confused about how much to save and who don't want to spend hours fiddling with more-complicated retirement planners. Ibbotson has done most of the heavy lifting for you, so now there's really no excuse not to get started.
Published April 10, 2008
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