Saving for Retirement

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How Much to Save for
Retirement?
A lecture for FIN 352
Professor James Dow
CSUN
(draft)
The Lecture
• How much do I need to save for retirement?
• We will cover:
– How to make a simple calculation.
– What makes the calculation more complicated in
practice.
Timeline of Wealth
Wealth
Add money each
year
Now
Withdraw money
each year
Date of Retirement
End of Life
A Three-Step Calculation
1) How much money do you need to withdraw from
your savings each year when you are retired?
2) How much wealth you need at retirement?
3) How much do you need to save each year to
accumulate that wealth?
A Word About Inflation
• Inflation will reduce the value of your savings
over time.
• To adjust for inflation, we will:
– Use current dollars for calculations.
– Use inflation-adjusted rates of return.
A Word About Uncertainty
• A number of uncertainties
–
–
–
–
Our expenses when retired.
The return on our investments.
The rate of inflation in the future.
How long we live.
• In our simple calculation, we will assume that everything is known for
sure.
• At the end of the lecture, we will look at how to incorporate uncertainty.
• The calculation of how much we need to save must be repeated each year
to reflect what we’ve learned over the previous year.
1) How much income per year?
• Start with your current income.
• Subtract the amount that comes from social
security or a pension.
• This equals the amount that you need to
generate each year from savings.
2)How much wealth does this require?
• A number of different ways to do this:
– Find wealth needed to generate income if no
uncertainty.
– “Monte Carlo” analysis.
– 4% Rule
3) How much will you have to save?
• Two interconnected decisions
– The amount you save each year.
– The asset allocation decision which determines
your expected rate of return.
A Simple Example
• http://www.choosetosave.org/ballpark/
• George is a 40 year old single man. He plans
on retiring at 65 and he expects to live for
another 20 years.
• He has no current savings.
1) How much each year?
• He makes $60,000 per year and believes he
can live on 80% of that when retired.
– 0.8*$60,000 = $48,000 needed income
• From social security and his pension he
expects to get $25,000 per year.
– $48,000 - $25,000 = $23,000 from savings
2) How Much Wealth at Retirement
• Assume that his savings after retirement earn
3% (after inflation).
• Wealth at retirement should equal the present
value of all the payments made in retirement.
• PMT=$23,000; I=3; N=20; FV=0
• PV = $342,182
3) How much to save
• How much must he put aside each year for
the next 25 years?
• Assume that his savings before retirement
earn 5% (after inflation).
• FV = $342,182; I = 5; N = 25; PV = 0
• PMT = $7,170
What if he can’t save that much
•
•
•
•
Start saving earlier
Retire later
Live on less during retirement
Invest more aggressively
Some Other Complications
• Already has money saved.
• Money in different accounts earn different
rates.
• Couples.
• Bequests.
Dealing with Uncertainty
•
•
•
•
Inflation
Rates of Return
Expenses
Life Expectancy
The 4% rule
• Pull out 4% of your savings each year.
• If your savings earn 4%, you can withdraw the
same amount of money indefinitely.
• $23,000/0.04 = $575,000
• $312,578 if you plan to exhaust your savings
in 20 years.
Insuring
• Medical and Disability Insurance
• Pay off mortgage before retirement
• Annuities.
Conclusion
• It’s important to plan for your retirement
needs.
• Because of the uncertainties, you can’t know
exactly how things will turn out.
• You can see if you’re on the right track.
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