Will there be any Social Security money left when you retire? (Part 3)

I get questions all the time about the viability of Social Security. Pretty much any one under the age of 35 tends to assume that there won’t be any retirement benefits left by the time they’re ready to stop working. Will social security be around when you retire? How much income can you count on? How do you create a retirement plan that would be successful either way? This series of articles attempts to answer those questions.

Part 3

Now that we have an idea of what we might get from social security, how do we use that information to put together a retirement plan? Here are the steps I used to create my plan, the same steps that I share with friends and family needing help to build their own retirement plans. I’ve also included an example.

Step 1 - First, figure out what annual income you’ll need in retirement: the closer to retirement, the more accurate your number, but when in doubt, use your current income as a guide. Once you have this number, the rest is just math that an online calculator or Excel spreadsheet can help determine. Budget items that you might adjust in retirement would be the money you spend on clothes (probably lower); the amount of taxes you pay into social security (likely zero); your commuting costs (should be much lower); and healthcare and recreation (will likely increase).

Let’s use as our example a 30-year old single person – we’ll call her Anne. Anne is currently making $50,000 per year. That’s the number we’ll use as her income needed in retirement.

Step 2 - Subtract your social security income you estimated from the second article in our series from the annual retirement income you figured in step one. If you have a pension, you’ll want to subtract that as well. What’s left over is the annual amount you’ll need to cover from your 401(k), IRA, Roth IRA, pension or other savings.

In our example, we’ll assume social security income of $1500 per month, or $18,000 annually. Anne’s $50,000 retirement income, minus $18,000 in social security leaves $32,000 per year that needs to be generated from other sources.

Step 3 - A potential retiree needs enough in her 401(k) to generate $32,000 a year. How much savings will produce that $32,000? A rule of thumb many planners use is the 4% rule. A lump sum can generate 4% in income each year, increased annually by inflation, and still has a high likelihood of lasting beyond 30 years. To determine our lump sum, we’re going to divide our annual income need by 4%.

$32,000 divided by .04 is $800,000. That’s the lump sum needed at retirement to generate, when added to her social security, enough to live on (you can check your math by multiplying $800,000 by 4% and you’ll get $32,000).

Step 4 - How much have you saved to date? The difference is what you’ll need to save between now and your retirement date. This may seem like a huge gap, but don’t panic just yet (plenty of time for that later 😊). It’s not only your savings that will bridge that gap – compound interest on what you’ve already saved, your future savings, and compound interest on that savings will all help.

For our example, let’s assume our 30-year old has only saved $5000 in her company 401(k). She’ll need an additional $795,000 over the next 35 years (she wants to retire at age 65).

Step 5 - There are countless calculators to figure the monthly contribution necessary to amass that $795,000 (a link to one is below). They’ll all require the number of years until you begin withdrawing, and some percentage rate of return. The number of years should be pretty easy to come up with, but what the heck should we use as a rate of return? The long-term (over the last 100 years) return of the stock market is approximately 10%. The next 100 years may be higher or lower, but that’s where we’ll start. You have to take inflation into account. Over that same hundred years, inflation has averaged around 3%. Subtract the inflation rate from the long-term market return, and you’re left with 7%. That would be the return of an all-stock retirement account – pretty aggressive for someone in their 50’s, but more appropriate for our 30-year old. You can use a lower number to be a bit more conservative, and to simulate a chunk of your portfolio being in bonds or cash. I would use the calculator to run the numbers with several different rates of return (perhaps 5%, 6% and 7%). That will give you an idea of how being more or less aggressive will impact how much you’ll need to save.

For our young (at 30, she’s younger than me) single person, we’ll use the 7% number to start. We’ll plug in 35 years to save, a starting amount of $5000, a goal of $800,000, 24 deposits a year (twice a month) and a 7% return. The result is a twice monthly contribution of $205.26 to get to the lump sum of $800,000. That’s a little bit shy of $5000 in contributions per year (some of which may come from her employer in the form of matching). If she’s making $50,000 per year, that’s saving 10% of her salary in her 401(k). Just to show you how the numbers increase, if we were to use a 6% rate of return, she’d need to save $279.92 per paycheck ($6718 or 13% of her salary). At 5%, she would have to save $351.34 per paycheck ($8431 or 17% of her salary).

https://financialmentor.com/calculator/savings-goal-calculator

Step 6 - If the number you came up with in step five above is one that works for your budget, the return you come up with will determine your asset allocation. The closer the return to 7% you choose, the more of your savings will have to go to equities. If you’re more conservative, than your mix of investments will reflect that: a 5% rate of return would be the historical result of a 60% stock/40% bond portfolio. In our example, we’re using the 7% rate of return, meaning all stock investments in the retirement account.

Step 7 - Once you’ve determined a rough asset allocation, then you need to pick which stocks, bonds, mutual funds, real estate or cash will go into your retirement account. That level of specificity is beyond the scope of this article, and will likely be dictated by the choices you have in your workplace plan.

Step 8 - The last step is to monitor your plan annually, adjusting back to the asset allocation you came up with in step six. In our example, we were using 100% equities, so this reallocation is pretty easy. If you used 5%, or a 60/40 mix of stocks and bonds, you’ll want to determine your percentages a year from now, and then sell whichever is above the mark and put that money into the other asset type. If we have a good year in the stock market, and your balance grows from 60/40 to 65% stocks/35% bonds, then you’d trim that 5% from stock portion and use it to add to the bond allocation.

This is only a rough estimate, but you will get more accurate as you get closer to retirement, and it’s much better to have general approximation than to fly blind and hope for the best (that leads to eating cat food or living with your kids). In addition to having a rough estimate, I’d suggest getting some professional help when you are 5-8 from retirement. A financial planner can take your rough estimate and make it much more precise. In our next post, I’ll share some of the rules of thumb and formulas we used in this article.