Get Real
Presenting U.S. News's ultimate retirement calculator--the essential tool you need to plot your strategy for the future
Most of us guess how much we should save for retirement by using what Sylvester Schieber, a pension expert with Watson Wyatt Worldwide of Bethesda, Md., calls the "look around" method: We look around at how people older than ourselves are doing--parents, neighbors, or colleagues--and take our cues from their example.
But there's a problem with this approach. "It works just fine in a stable environment," says Schieber, "but today's retirement world is very unstable." To plan for a future in which Social Security and Medicare may or may not be there when you need them, in which private pensions are uncertain, in which you may live in retirement for one year or 40, you need some hard numbers, and you need to do some hard thinking.
Plenty of people want to help you; mutual funds offer what they call retirement calculators, and so do brokerages. The problem with most of them, however, is that they've been developed as sales tools, and often contain critical assumptions that are either naive or inappropriate to your individual circumstances.
Some predict full Social Security benefits after retirement, others none. Worse, many of the underpinnings are unstated or unconsidered. The mathematics of compound interest used in retirement calculators is not particularly difficult, but figuring out the right assumptions to put into their equations, such as the rate of return you'll earn on your savings and the number of years you'll be living in retirement, is enormously challenging, requiring not only some knowledge of economic history but a good grasp of political developments and the changing realities of human life expectancy.
That's why U.S. News has teamed up with Watson Wyatt Worldwide to develop what we hope will be the only retirement calculator you'll ever need. It comes in two versions. One is the series of work sheets. A more sophisticated, interactive version is posted on our Web site. What distinguishes both of them is not just that they allow you to tailor your calculations to your individual circumstances but that they give you the background information you need to decide what assumptions you should reasonably make. Even minor changes in the assumptions you use can produce huge differences in results. We encourage you to experiment with different assumptions when filling out the work sheets so you get a sense of how much your current need to save for retirement depends on your beliefs about the future.
What are the most critical errors people make in choosing their assumptions? Here are the seven greatest mistakes of retirement planning:
The market power illusion I'll always get raises and I'll be able to work as long as I want.
Estimating your future earning power is important when planning for retirement for two reasons. First, if you can count on substantial raises in the future, this will reduce the proportion of your income you need to save now to achieve a given standard of living in retirement. For example, suppose you want to accumulate $500,000 over the next 30 years and can count on earning a 4 percent return above inflation on your savings. If your income today is $40,000 and you can count on receiving 5 percent raises over inflation each year, then you need save only 11.6 percent of your income to achieve your objective. But if your raises average only 3 percent, you'll wind up more than $121,000 short of your goal.
There is a second, more subtle truth to remember about raises: If your income keeps rising, you'll probably expect a higher standard of living in retirement, which will increase the total savings you'll need to accumulate. Many of today's affluent retirees, for example, would not be pleased if forced to return to the same standard of living they had at age 25 (even if they might yearn to be 25 again for other reasons). Thus, if you do receive an unexpectedly large raise and develop more expensive tastes as a result, you'll probably want to recalculate your savings needs.
What sort of raises should you expect over your remaining lifetime? It's great to believe in your own star, but it's also useful to know what the law of averages says. Frank Levy, an economist at the Massachusetts Institute of Technology, has studied the wage history of families of different ages and different levels of education. Families headed by a man with only a high school degree have fared particularly poorly in recent decades. A husband in such a family who was 30 years old in 1979 typically saw a rise of only 12 percent in his income by the time he turned 40, after adjusting for inflation. After that, his real income actually declined, and by age 45 he was making less than at age 30 in real terms.
College graduates in the same age group had more upward mobility, but still far less than their fathers enjoyed. In families headed by a man with a college education, the husband typically saw his income rise by about one third between ages 30 and 45--just over 2 percent a year.
In estimating your own earnings prospects, beware of overgeneralizing from early successes. For most workers, wage gains peak in their 40s. For example, among husbands age 40 in 1979, even those who were college graduates saw relatively flat earnings before they turned 55, and those with only a high school education lost ground. Assuming a career average of 1 percent real wage growth per year, which is what the calculator reproduced in these pages assumes, is probably prudent for most people (the version of the calculator on our Web site allows you to pick your own number).
Projecting how long you'll want to work, or how long you'll be able to, also depends on individual circumstances, but, again, caution is in order. Older workers in the next century may well be more valued, since there will be relatively fewer younger workers competing for their jobs. Still, you shouldn't assume you can work forever at the wages you think you deserve. Rapid technological change is likely to continue, rendering job skills that are lucrative today obsolete. Today, 70 percent of men over 60 are no longer in the work force, and more than a few feel pushed out.
The bull-market illusion I'll make the same return on my savings in the future as I made in the past.
From 1982 to 1997, the stock market yielded a compound annual average return of 12.8 percent, even after adjusting for inflation. Can you count on having this performance continue? Many boosters now proclaim the existence of a new economy, built on high technology and streamlined management, that will lift American productivity and stock values ever higher. But the lessons of economic history suggest otherwise. According to Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania, the long-term real return on stocks has been just 7 percent.
Does this mean it would be prudent to assume that you, too, will earn 7 percent over time? If you do, you should be aware of the risks. Never mind the Great Depression; if you'd begun saving for retirement in 1953 by investing in a portfolio of all common stocks and had made equal investments each year through 1973, the average annual real return on your portfolio would have been -0.65 percent. Too bad if 1973 happened to be the year you wanted to retire.
Because bull markets are inevitably followed by bear markets, many financial advisers suggest putting an increasing share of your retirement portfolio into bonds as you age to protect money you can't afford to lose. But the long-term real return on bonds is only 3.5 percent, and for long periods the return has been negative; between 1966 and 1981, the average real return on bonds was -4.2 percent. History suggests that a prudently mixed portfolio of stocks and bonds will earn substantially less than 7 percent over the long haul.
Also uncertain is what effect aging baby boomers will have on markets once they begin to draw down their savings in retirement.
The nest-egg illusion There's enough money in my 401(k) to buy a minivan; I must have enough to retire on.
In 1995--the latest year for which data are available--more than half of all families headed by a person 35 to 44 had retirement savings; the median amount was $25,000. Assuming a prudent real return--let's say 4 percent--$25,000 will grow to $54,778 over the next 20 years. That may sound like a huge amount, but how far will it go? If you retire at 65 and live to 90, a nest egg of that size will allow you to spend just $3,500 a year without depleting your savings before you die.
The mortality illusion I'll live to about the same age as my parents did.
People tend to underestimate their life expectancy, and it's not surprising. It's the look-around problem again: You generalize from life spans of older friends and family members and figure that's what's in store for you, too. But in an era of rapidly improving life expectancy, the look-around method once again gives the wrong answer.
Life expectancy at age 65 today is 15.6 additional years for men and 19.2 for women. For both sexes, this represents an increase of more than two years just since 1970. By the time the youngest baby boomers turn 65, the Social Security Administration projects that life expectancy at that age could be as high as 18 more years for men and 21 years for women. Note that everyone runs very nearly a 50 percent "risk" of living longer than their life expectancy.
That reality makes retirement planning exceptionally difficult. On the day a husband and wife turn 65, they may have only a year or two of living between them to finance, or they may have 70. A good rule of thumb might be to plan against the possibility that you will outlive three quarters of the people in your age group--an actuarial calculation our Web site calculator allows you to make. You may not want to deny a child a college education just so you are sure to have enough money to celebrate your 95th birthday, but you also don't want to become a burden on your children just because you unexpectedly live to be 10 years older than the average life expectancy for people your age.
The health care illusion Managed care and other measures will control the cost of health care when I retire.
Although you'll probably live longer than you imagine, don't count on being healthier. The need for and the cost of health care typically increase dramatically as you age. On average, for example, a 40-year-old man consumes about $2,000 a year in health care services, whereas a typical 75-year-old consumes five times that much. That's why, as the population ages, huge inflationary pressures are put on the health care system.
How big will those pressures be in the next century? Over the past 40 years, health care costs have risen an average of 70 percent faster than the general rise in prices--and that was before the boomers started to gray. The federal government predicts that by 2030, as boomers enter their 70s and 80s, health care spending will top $16 trillion, representing nearly 1 out of every 3 dollars in the economy.
Who will pay the bill? No one knows for sure, but it's a good guess that the next century's elderly will become responsible for paying a much larger share of their own costs than their counterparts do now. Eligibility requirements for Medicaid nursing-home benefits, for example, are likely to be tightened. Since the cost of a nursing-home bed is projected to be $97,000 a year (in today's money) by 2030, those who don't make provision for this potential liability could easily become impoverished.
Medicare, which covers medical costs for the elderly, is also likely to become less generous--limiting the conditions and treatments it covers, for example, or imposing higher deductibles and copayments or a means test. Reform is virtually certain; even after assuming huge increases in the efficiency of the health care system, the actuaries at Medicare project the system will go broke within 10 years.
How can you take these factors into account as you plan your own retirement? We suggest that you assume the cost of health care will rise by at least 3 percentage points above the general rate of inflation, which is close to the historical norm, and that you assume your entitlement to subsidized health care will be substantially reduced. This is one area where it's best to assume the worst--you'll be pleasantly surprised if things turn out better than expected.
The Social Security illusion I can count on Social Security to pay me the full benefits promised me under current law.
If you look at the problems of Social Security in isolation, they don't seem too daunting. Today, the program costs the equivalent of about 11 percent of wages; by 2035, the cost will be about 18 percent, and it won't reach 19 percent before 2060 even if no benefits are cut.
But Social Security doesn't exist in isolation. As we've already seen, the cost of Medicare and Medicaid will skyrocket as well; so will the cost of veterans' benefits, pensions for civil servants, and similar entitlements. The federal government spends nine times more on the average senior citizen than it does on the average child. This means that as the population ages, federal spending grows geometrically. If left on its current course, entitlement spending would consume all federal revenues within 33 years (goodbye national defense, the court system, and interstate highways). It's hard to imagine that a spending program as large as Social Security can remain exempt from budget cuts.
But it's also naive to imagine that Social Security will simply disappear. Today, Social Security is the primary source of income for 66 percent of elderly Americans. This degree of dependency is unlikely to lessen in the future, if for no other reason than today's low savings rate. Indeed, as private pensions become less generous and health costs rise, the elderly could easily be the country's fastest growing poverty group in the early decades of the next century. Even if Social Security disappears in name, the country will somehow have to make provision for huge numbers of elderly poor.
The implication for you? If you believe Social Security and other entitlements will pay you full benefits, then you had best assume as well that your taxes are going to increase dramatically. To keep Social Security and Medicare solvent just through 2035 would require a combined payroll tax of between 24.5 and 33.8 percent, for example.
More realistically, you can probably count on Social Security or something like it to offer subsistence benefits in the event that you need them. But the program almost certainly will become less generous with the nonpoor. Congress has already increased the retirement age for future retirees and has imposed a kind of stealth means test by subjecting benefits to taxation at an income threshold that is not indexed to inflation. Under current law, all but the poorest retirees will pay taxes on their benefits at rates that are likely to be very high given the long-term pressures on the federal budget.
The affordability illusion With all the bills I have to pay, there is just no way I can afford to save more for retirement.
In 1946, real family income in the United States was just about half of what it is today, a baby boom was underway, and still the personal savings rate was nearly 2.5 times today's. How was this possible? It turns out that what people think they can afford to save is very subjective. A recent Public Agenda Foundation study asked a cross section of Americans whether they could afford to save more for retirement. At first, 48 percent said no, but when presented with options such as cutting back on eating out, vacations, or movies, more than a third of these conceded there was room for more savings. This is not surprising. The American "gaming" industry takes in some $40 billion a year in revenues. The average American household headed by a person age 35 to 54 spent over $2,100 on eating out in 1995, as well as $560 on entertainment fees and admissions and $331 on booze. The bottom line: Most Americans do have the means to make more provision for themselves in old age, if only they'll take the challenge seriously.
Log on to our site, www.usnews.com for an interactive version of our calculator.
THE ULTIMATE RETIREMENT CALCULATOR
HOW IT WORKS. The work sheet below is the first step in estimating how much you need to save for retirement. Each new work sheet will ask you about your own circumstances and educate you about factors that will affect your retirement.
WHAT YOU'LL NEED. Details of your savings and pensions. Plus a pencil.
MARRIED OR SINGLE? For two-paycheck households, we recommend that each wage earner figure retirement needs independently, making a common-sense split of items such as joint investments.
THE FINE PRINT. The results of these work sheets will only be as accurate as the assumptions you use.
WORK SHEET 1
What will it take to maintain my standard of living?
1. Enter your current annual income (before taxes).
Many retirees find their cost of living is lower than during their working years. Expenses such as commuting are a thing of the past; so are payroll taxes. And many retired people have paid off their mortgage. With this in mind, Watson Wyatt Worldwide, a benefits consulting firm, has drawn up the following table. It shows in percentage terms how much income a typical worker needs to replace to maintain his or her standard of living in retirement.
Health insurance status Age at retirement
after retirement 55 60 62 65 70
Single/covered by employer plan 0.64 0.68 0.71 0.74 0.74
Couple/covered by employer plan 0.68 0.71 0.73 0.75 0.75
Single/no plan 0.72 0.74 0.75 0.76 0.76
Couple/no plan 0.76 0.77 0.77 0.78 0.78
2. Using the table as a guideline, enter the percentage of income you wish to replace in retirement (use 0.75 for 75 percent).
3. Multiply line 1 by line 2. This is how much you'll need each year in retirement to finance your desired standard of living.
WORK SHEET 2
How much will I need to save for retirement?
1. Enter amount from work sheet 1, line 3.
The earlier you retire, the longer you'll need retirement income. The chart below estimates your long-term needs. It has built-in assumptions: You'll receive 1 percent annual real wage increases, you'll live to age 90, and you'll leave no estate.
Years until you retire
Retirement age 0 5 10 20 30 40
55 19.4 20.2 21.2 23.5 25.9 28.6
60 18.0 18.7 19.7 21.7 24.0 26.5
62 17.3 18.0 19.0 20.9 23.1 25.5
65 16.2 16.9 17.8 19.6 21.7 24.0
70 14.1 14.7 15.5 17.1 18.9 20.8
2. Enter the factor that most closely applies to you.
3. Multiply the amount in line 1 by line 2. This is your lifetime retirement savings need, before adjustment for changes in benefits and tax rates.
WORK SHEET 3
What happens if Medicare is reduced?
The Medicare trust fund is officially projected to be exhausted in 10 years. Because of this, there is a strong possibility that Medicare benefits will be less generous in the future. On line 1, enter 1 if you don't expect to collect Medicare, 0 if you thin Medicare will continue as is. Enter a fraction if you expect partial cuts (e.g. .25 if you expect a 25 percent cut).
1. Amount by which insurance value of Medicare will be cut.
2. The current annual market value of your entitlement to Medicare is: $5,058
3. This is the amount of health care insurance you'll need to replace.
Multiply line 3 by a health care inflation adjustment factor * from below
Years until you retire
Retirement age 0 5 10 20 30 40
55 28.8 33.4 38.8 52.1 70.0 94.1
60 24.9 28.8 33.4 44.9 60.4 81.1
62 23.4 27.3 31.5 42.4 56.9 76.5
65 21.5 24.9 28.8 38.8 52.1 70.0
70 17.6 20.4 23.6 31.7 42.7 57.3
4. Here is how much extra you'll need during your retirement to replace the Medicare cuts you expect.
*Factors assume health care costs increase at 3 percent over the general rate of inflation.
WORK SHEET 4
What will my Social Security benefits be worth?
1. Enter your current annual earned income.
The factors in the table below, multiplied by 100, tell you approximately what percentage of your income Social Security currently promises to replace. If you believe benefits will be cut by the time you retire, choose a smaller factor. Multiply line 1 by the factor you choose and enter the result on line 2. Note, however, that the amount on line 2 must not exceed the maximum Social Security benefit of $16,104.
Current pay $15,000 $35,000 $55,000 $75,000 $95,000
Full-benefit factor 0.5 0.37 0.29 0.22 0.17
2. This is your expected annual Social Security benefit. Multiply this amount by an adjustment factor from the table below.
Years until you retire
Retirement age 0 5 10 20 30 40
55 11.2 11.3 11.6 12.5 13.2 14.6
60 12.9 13.0 13.4 14.5 15.3 16.9
62 13.7 13.8 14.2 15.4 16.2 17.9
65 16.1 16.7 16.6 18.3 18.8 20.8
70 16.4 18.0 19.9 22.5 23.9 25.8
3. Lifetime value of your Social Security benefits (again, assuming you live to age 90)
WORK SHEET 5
How much will my private pension be worth? *
If you are entitled to a defined-benefit pension (not a 401(k)) from an employer, an easy way to complete this work sheet is to call the plan administrator and ask for your annual estimated benefit at retirement age; enter it at line 4. You can also use steps 1-3 to obtain an estimate for your current job.
1. Enter your current annual salary.
To determine your final pay, enter the appropriate adjustment factor below (factors assume your raises will average 1 percent per year).
Years until you retire 0 5 10 20 30 40
1 1.03 1.08 1.2 1.32 1.46
2. Multiply the appropriate factor times line 1. This is your estimated final salary.
3. Enter your total years of service at the time you plan to retire.
4. Multiply line 3 by line 2 and divide by 100. This is your estimated pension benefit.
Enter the appropriate factor from the table below to adjust for possible early retirement and length of retirement.
Age at retirement 55 60 62 65 70
Age factors 7 8.9 10.4 12.5 11.3
5. Multiply this factor times line 4. This is the lifetime value of your pension benefits.
* If you have never participated in a defined-benefit pension plan, enter 0 at line 5.
WORK SHEET 6
How much will your current retirement savings be worth?
1. Total retirement savings (before taxes)
Include here any stocks, bonds, savings accounts, individual retirement accounts, etc., that are for retirement purposes. Also include your current balance in employer-sponsored retirement savings plans, such as 401(k)'s or Keoghs.
Enter the appropriate factor form the table below, which estimates how much your savings will accumulate.
Years until you retire 0 5 10 20 30 40
Aggressive assumption 1 1 1.40 1.97 3.67 7.61 14.97
Prudent assumption 2 1 1.22 1.48 2.19 3.24 4.80
Cautious assumption 3 1 1.16 1.34 1.81 2.43 3.26
[Footnote] 1 Your investments earn long-term average stock market return, or 7 percent after inflation.
[Footnote] 2 Average 4 percent return after inflation, giving you some protection against volatility.
[Footnote] 3 Average 3 percent return after inflation.
2. Lifetime value of your current personal savings.
WORK SHEET 7
How much do I need to save for retirement?
1. Enter retirement needs estimate from work sheet 2, line 3.
a. Enter adjustment for lost Medicare benefits from work sheet 3, line 4.
2. Add lines 1 and 1a: This is your total retirement need before adjustment for changes in taxes.
3. If you believe your income tax rate will be higher or lower when you retire than it is now, enter the change you expect. For example, if you expect your tax rate to rise 5 percent after retirement, enter .05. If you expect no change in your tax rate, enter 0.
4. This is roughly the increase or decrease in your savings requirement due to changing tax rates.
5. Add line 4 to line 2. This is your total savings requirement after adjusting for changing tax rates.
6. Enter value of your current retirement savings and expected benefits.
a. Value of Social Security benefits (work sheet 4, line 3)
b. Value of pension benefits (work sheet 5, line 5)
c. Value of current savings (work sheet 6, line 2)
d. Total value of expected retirement benefits and current savings (add 6a, 6b, 6c)
7. Total future savings required until retirement (subtract line 6d from line 5). (A negative number represents excess savings--stop here!)
To calculate how much you need to save each year, enter the appropriate factor from the table below.
Years until you retire 0 5 10 20 30 40
Aggressive investments 1 0.156 0.060 0.017 0.007 0.003
Prudent investments 1 0.178 0.078 0.030 0.016 0.009
Conservative investments 1 0.185 0.086 0.037 0.021 0.013
8. This is how much you need to be saving this year.
9. Divide line 8 by your current income and multiply the result by 100. This is the percentage of your income you should be saving.
This story appears in the June 29, 1998 print edition of U.S. News & World Report.