Opinion: Complete this 11-point exercise and learn when you can retire

Published: June 21, 2017 8:56 a.m. ET


And afterward, craft an action plan

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PaulA. Merriman


One of the most frequent questions I hear is a variation on this: "How will I know when I have enough to retire?"

The answer is different for every person or household.

You start by gathering some facts. Then you make a couple of crucial assumptions, figure out how much risk you are willing to take, and finally you make an action plan based on what you have learned.

To do this, you don't need an advanced education, and the numbers you need don't have to be precise. In fact, there are enough important unknown variables that precise planning isn't really possible.

In this article, I'll outline an 11-point exercise that will tell you whether you are on track to retire when you want to.

Once you complete these steps, your situation is likely to become much clearer and less mysterious.

Data point one: Your current cost of living. This is the bedrock number on which everything else is built. A quick-and-dirty approach is to identify your current household income, subtract payroll taxes and whatever you are saving for the future. What remains, presumably, is what you're spending on your life right now.

I suggest you convert the numbers to annual figures.

Data point two: The rate of inflation you assume for the future. This is a wild card, but it's vital: Inflation will have a big effect on your financial future. When I talk to investors, I often use an assumed inflation rate of 3%. That may not seem like much, but over the years it can do more damage than you might think.

Data point three: How many years until you retire. This isn't always a simple number, since retirement isn't an off-or-on switch, and for a variety of reasons you may not be in control of when you stop working.

However, this exercise requires at least a ballpark number of working years you still have ahead. So do your best here.

Data point four: Your cost of living after you retire. Start with your current cost of living and try to anticipate big changes.

After you retire, you probably won't pay so much for clothing and commuting, and you won't have to keep saving money for retirement. But there will be other changes you may want or need to make.

Look at your big spending categories and make some assumptions about changes you'll likely make.

Based on my experience with real-life people, I suggest you add a cushion of 5% to 20% to that number. If you base your retirement on that, I think you and your family will eventually appreciate it.

Next, focus on where the money will come from.

Data point five: Retirement income you can count on. For most people, this category will include Social Security. It might also include a pension, rental income or notes receivable.

You will almost certainly have investment income such as interest, dividends or expected capital gains. But don't include that here; it will come into play later.

Data point six: Retirement income you'll need from your portfolio. If you've done your homework so far, this data point is nothing more complicated than elementary-school math: You have assumed a future cost of living for when you retire. You know what you can count on. The difference will need to come from your portfolio.

Data point seven: Size of the portfolio you'll need at retirement. If your investments are properly diversified and properly balanced between stock funds and bond funds, you can get a quick-and-dirty answer by multiplying your answer to data point six by 25.

This assumes you will withdraw 4% of your portfolio's value the first year you're retired, then adjust the number every subsequent year to cover inflation.

I want to stress that 4% (25 times your projected cost of living) is only a rough rule of thumb that will tell you whether you are in the ballpark of retirement savings. Many advisers suggest you take less risk by using a higher multiplier.

You might try multiplying your answer to data point six by 30 or even 33. That will mean you need more savings, but it will give you a greater probability of meeting your retirement goals without undue stress.

Data point eight: The current size of your investment portfolio. This number should include only your savings and investments, but not real estate and other non-liquid assets.

In addition to stocks, bonds, mutual funds, IRAs, 401(k) and similar accounts, your portfolio may include cash, certificates of deposit, Treasury bills or notes as well as loans payable to you that you reasonably expect to be paid by the time you retire.

Data point nine: Your current annual retirement savings. Actually, this is a number you should already know from the very first calculation you did when you determined your cost of living.

This will tell you how much you'll add to your portfolio before you retire, assuming you stay on your current trajectory.

Data point 10: The return you have been making on your investments. Every serious investor should know this number, but in my experience most people don't. If your investments are scattered among IRAs, retirement accounts and perhaps some taxable accounts, nobody is going to compute this number for you.

A financial professional can help you with this. (More on that momentarily.)

Data point 11: The annual portfolio return you need from now until you retire. To figure this out, you'll need a financial calculator or a computer spreadsheet.

You know what your portfolio is worth now. You know how much you'll add every year. You know where you need to wind up, and when. From that information, a financial calculator can, in the blink of an eye, tell you the investment return that will get you there.

(Don't have a financial calculator? Find one online at feedthepig.org, a site sponsored by the American Institute of Certified Public Accountants. You'll find calculators for almost every planning need.)

Ideally, the answer will be similar to the return you have been achieving. If it turns out you will need a substantially higher return, this will tell you that you should do one or more of the following:

  • Save more money.
  • Plan to retire later.
  • Plan to spend less in retirement or work part-time so you take less out of your portfolio.

This is extremely useful information, because it takes information that came directly from you and shows you how to turn it into a call for action that is quantifiable.

I want you to know that I do live in the real world, and I know most people won't do all the things I'm recommending, even though this exercise is essential if you want to maximize your chances for a financially successful retirement.

That leads me to a final recommendation: Get a professional to help you with these things.

If you do your homework well and choose a good professional to help you (somebody who does not have any products for sale), the time and money it costs will be well worth it. You'll have the facts that you need, and you'll have a plan.

If you carry out that plan, your life — and the lives of your family members — will undoubtedly be changed for the better.

Meanwhile, check out my latest podcast: "Invest now or wait for the next correction."

Richard Buck contributed to this article.

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