Retirement savings are a critical part of your financial security. Whatever expenses you cannot cover through Social Security, Pension, or post-retirement employment must be made up by your savings. The question as to whether you have enough money to retire is fundamentally a question about how long you savings will last – in other words how long you will be able to cover the expense gap left after you consider your other sources of income. Subtract your anticipated retirement expenses from your anticipated retirement income and if there is a positive difference this is the gap that must be covered by your savings.
However, herein lies the rub. Retirement savings is a source of income that accumulates over time as you save through your working years. Let’s say that you are ten years away from retirement. How do you figure out what you savings will be when that magic day comes? This can be rather complex because a number of factors come into play including your monthly savings rate, matches by your employer, and investment returns.
We need a way to forecast the balance from now until your planned retirement date. There are a couple of steps you need to follow to do this:
First and foremost, you need to develop a spreadsheet that tracks the monthly savings balances for each of your retirement savings accounts. These data points will allow you to establish a trend. The more individual months of data you have to do this, the better the forecast will be. I have been collecting end-of-month totals on my accounts since 2002. The more monthly data points that you have the better. If you have not been doing this for your accounts you need to. I would not attempt a forecast with less than six monthly data periods and preferably 12 months or more. I go on-line and gather this information for my accounts on the day following the last day of each month.
Second, you need to determine what the growth trend has been. The metric that I use is the compound annual growth rate (CAGR – pronounced Kegger, but it has nothing to do with beer). CAGR is nothing more than the growth rate over time adjusting for a changing savings balance (see the discussion of compounding below).
The last step is to take the growth rate you calculated from the trends in your savings data and extrapolate this to your proposed retirement date. How do you do this?
- You could create a line graph from the data in your spreadsheet leaving the months from now until your retirement date blank in the graph. Then using a sophisticated scientific instrument such as a ruler, draw a straight line through the data and read the savings total where the line intersects your retirement month.
- However, there is a much better approach available because the ruler technique above misses one very important dynamic that you get when you save over time. That dynamic is called compounding and here’s how it works. Let’s say that at age 45 you have $100,000 in a saving accounts and that balance grows at a 10% annualized rate. At the end of the year you would have gained an additional $10,000 ($100,000 x 10% growth rate = $10,000). Over time your savings balance should increase with help from the market and your contributions. Now fast-forward to age 60 and you balance has grown, for example to $650,000. That same 10% growth rate now would yield $65,000 ($650,000 x 10% = $65,000). This is the magic of compounding and this dynamic is picked up in the CAGR calculation. You see, as your savings grow over time, the same growth rate will produce greater dollar gains. As you approach retirement, you may get a boost that you weren’t expecting. Of course, if the market crashes, it could work to your detriment as well – but, let’s keep a positive attitude here, shall we.
Now, I am betting that many of you are saying that you haven’t been collecting the end of month totals for your retirement savings account and even if you have been, forecasting sounds very complex. To this, I would say two things:
- You need to start collecting this information as a disciplined approach to managing your investments. I am offering you an approach to figure out what financial resources you will have to work with when you retire. However, without this data, it can’t be done. So, start with your balance for the most current month. After six months or a year you can begin to assess your retirement savings balance. Once you have this data collected, there are on-line tools that will help you forecast.
- Now let’s say that you have not been tracking your retirement savings balances on a monthly basis. Are there any alternatives that you can use until you have enough data to do a proper forecast? The answer is yes. Take your most current savings balance and extrapolate this balance out to your retirement date using an investment return estimate that you come up with. It could be what you think you have gotten historically on average. In a spreadsheet put the current balance in a cell. Now determine how many years you have until retirement and extrapolate your current balance out to your retirement date.
- I can give you an example. Let’s say that you believe that you have been getting a 10% investment return on average in the past, your current savings balance is $500,000, and you are 5 years away from retirement. Start by multiplying the $500,000 balance by 1.1 (a 10% growth rate). That will give you the estimated balance at the end of next year ($500,000 x 1.1 = $550,000). Now for the balance two years out, multiply the $550,000 by 1.1 and you will get an estimated savings balance of $605,000. Repeat this process through each of the remaining years until retirement and that will be your estimate of your savings balance at retirement. The better your estimate of the investment return, the better the forecast. So, it is worth your time to nail this down as accurately as possible. This is a good stopgap approach until you have enough data to do it right.
Forecasting your retirement savings sounds a little technical and complicated. However, simple tools are available on-line that can help you. Knowing what you have to work with when you retire is critically important and it is worth your effort to get this right.