How on Earth can you fathom how much income you will need when you retire? A good first step when retirement planning is to know how much you need to live on now.

For a realistic answer, you can use a budget-planning tool like Money Saving Expert’s Budget Brain to capture your current spending.

I like this tool because it’s like holding your finances up to the Snow Queen’s mirror. It will give you the true picture of your outgoings – warts and all – by speaking plainly about areas that might otherwise be overlooked, such as dental expenses or beauty therapies. (I spend a lot on virgin’s blood, myself).

Will I really need so much income when I retire?

It’s commonly held that we spend less in retirement than in the buccaneering days of youth, so you can probably strip out:

• Mortgage payments (assuming you have paid it off by retirement age)

• Work related expenses

• Child related expenses

But retirement isn’t all about sitting atop a hoard of your treasure, saving pennies with coupons / cruising the Caribbean, and writing letters to Radio 4.

For instance, you might consider upping your allowance for:

• Travel costs

• Health

• Heating

• Werther’s Originals

Once you’ve done all that, you should have a reasonable base figure for the annual income you’ll need to hit on the retirement calculator.

A few wrinkles

If you’re having trouble picturing your retirement, try this gimmicky but fun retirement income calculator that can help you visualise a life of permanent leisure luxury.

Meanwhile, this retirement calculator lets you pick your desired monthly income, then crank the handle to see how fortune plays out.

Remember that the higher your target income:

• The longer you will need to save,

• Or the more you will need to save,

• Or the higher your growth rate will need to be (which implies a riskier asset allocation),

• Or some combination of all the above.

Working out how much you will need when you retire is just one part of creating your retirement plan, so do subscribe to Monevator for more pointers.

There was a period in my life when I couldn’t bear to think about retirement planning. I didn’t know how to do it. I didn’t think I could afford it. I only knew the problem grew worse with every day I ignored it.

So I blanked it out. It was a big, self-inflating ball of worry but it was invisible. Like a personal climate change problem, I pretended everything was hunky-dory by shutting off the voices of doom in a soundproof part of my brain.

If only I knew how easy creating a workable retirement plan could be!

First things first: It’s vitally important to define your investment goals. Without knowing your destination, you can’t work out how to get there.

A large-scale, life-altering project like investing for retirement may seem too abstract, distant, and difficult to deal with. Yet it can be done quite quickly by stringing together a few logical steps and employing a retirement calculator to crunch the numbers.1

Creating your retirement plan

Before the calculators can whir, we need to sketch out our retirement vision and the key factors that will make it happen.

• My vision – To build an annual income that will sustain me and my nearest and dearest once we can no longer work.

• Target – The annual income I need to live on in retirement. Another way of approaching this is in terms of total pension pot.

• Time horizon – e.g. I want to retire no later than age 65.

• Contribution level – Most calculators ask for the percentage of income that will be fed into your pension funds, but ultimately this comes down to how much cash you can save.

• Expected rate of return – What growth rate might we get from the mix of assets we choose for our portfolio?

To make my retirement plan a little more tangible, I’ve taken to thinking of it as my very own financial farm:

• My target income is the crop that I’ll be harvesting in the years to come.

• My contribution level is the seed that I sow.

• The time horizon is the length of the growing season.

• The expected rate of return is the effect of the financial sun, rain, and soil upon my crop.

• I can even throw on fertilizer to increase the expected rate of return by choosing a riskier asset allocation.

Over the rest of this Special Retirement Week On Monevator! I’ll look at how to turn the factors above into raw numbers that you can feed into a retirement calculator.

As we go, we’ll look at each issue in turn (and magically the four bullet points below will be updated with links, too):

• Target: How much do I need to live on in retirement?
• Time horizon: How long have I got until I retire?
• Contributions: How much money must I save to achieve my goal?
• Expected rate of return: Working out your asset allocation

Subscribe now to get each new part emailed to you every morning.

Creating a retirement plan is worth the effort

Your investment goals face no bigger threat than the prospect of you giving up part way through.

By investing some time in your plan, before you invest any money, you will make your goals more tangible. You get a sense of what mission accomplished will look like, and can then draw a deep breath and take on the challenge.

After a while, you will savour your progress, relish defeating your demons, and turn a mental block into an empowering positive in your life. (Honestly!)

Take it steady,

The Accumulator

1. Beware that results can differ depending on which calculator you use. Use them as a guide to planning only, always check the assumptions used by the calculator, and appreciate that reality could turn out very differently. [↩]

Good reads from around the Web.

This week saw the well-respected bond titan Bill Gross predict the death of equities:

The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well.

The key thrust of Gross’ argument is that:

[Equities’] 6.6% real return belied a commonsensical flaw much like that of a chain letter or yes – a Ponzi scheme. If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year.

Unfortunately, Gross appears to have made a (wait for it) gross error. As the likes of Jeremy Siegel and Henry Blodget have pointed out, he has forgotten that a large part of that 6.6% real return consists of dividend payouts:

Stocks have not, in fact, “appreciated” at ~7% per year for the past couple hundred years. Stocks have only “appreciated” about 2% per year.

That is to say, the prices of stocks, after adjusting for inflation, have only risen about 2% per year for the past couple of centuries.

So where has the rest of the return come from?

Dividends.

Over the past century, about 4 points of the ~7% annual return of stocks has come from dividends.

This would seem to be an inordinately huge error, but Gross has yet to address it. Instead he and Siegel have traded insults across the financial media:

“I like Bill Gross a lot, but he’s got the economics wrong,” Siegel said on Bloomberg Television’s “In the Loop” with Betty Liu. Siegel is “obviously pushing at windmills,” Gross said today in an interview with Liu. “He belongs back in his ivory tower,” Gross said.

Miaow!

A load of crystal balls

Other critics have noted that plenty of US companies get much of their earnings from overseas. Thus their business value would be geared to global GDP, not to US GDP alone.

But the main thing I takeaway from this spat is that fun as it is to read the word of gurus and pundits, an investor shouldn’t regard any of it too seriously. (That includes any forecasts that stray onto Monevator, for that matter).

If a multi-millionaire bond king with billions under management like Bill Gross can make such a simple slip, do you really think an economist has a clue when he says Russian GDP will pick up in 2014, or that the FTSE will fall below 4,000 before rebounding to 10,000, or any other comically precise forecasts?

[continue reading…]