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A Quick Back-to-School Financial Review

David Edwards

09/14/00 - 02:05 PM EDT

The kids are back in school, the tan's fading, time to get serious again. So here's a 10-minute financial review for you to determine, all fantasies aside, whether you're on track to meet one simple financial goal -- retirement.

If you're 35 now and in reasonable health, you have a good chance of living past 80. So any financial plan that assumes you'll draw your retirement assets down to zero by, let's say, 75 could put you in a bind. Furthermore, you might be interested in leaving an estate. How much do you need in assets to cover your future income requirements?

First, how much income do you need in retirement? Financial planning software generally recommends 70% of your final working year's income, adjusted for inflation. We generally find, however, that our clients' expenses don't drop that much in retirement; they spend less on middle-age expenses like housing, furnishings and children, but spend more on leisure activities and medical care. A simplifying assumption is that your retirement income in the future has to be at least as high as your current income.

In retirement, a portion your income will be provided by Social Security. Full benefits kick in at 65 -- call 800-772-1213 for a statement estimating what these benefits will be. You may also be the beneficiary of a pension plan. Call your company benefits department to determine the cash available from that source.

How much money do you need so that, no matter what, you never run out of money in retirement?

Let's assume you and your spouse currently make $200,000 per year, plan to retire in 20 years at 65, will have Social Security benefits of $20,000 per year and other pension benefits of $30,000 annually. If $50,000 is covered already by Social Security and pensions, you'll need additional assets to cover the remaining $150,000.

A good rule of thumb is that you can draw down between 5% (conservatively) and 8% (aggressively) from your retirement assets and never run out of money. These numbers are derived from simulating a typical retirement portfolio (which might be 60% equities and 40% bonds) over the 20th-century experience of returns from stocks and bonds. Once you get above an 8% drawdown rate, there is the risk that a series of off years combined with a high draw rate would cause your total assets to decline.

Click here to download a simple spreadsheet model to do some "what if" estimating. (Netscape users should save this file to their hard drives and open it in Microsoft Excel.)

Substitute your own values for the numbers in blue. This model calculates your shortfall under various scenarios or tells you that you'll be OK. It also projects what will happen if you make additional annual contributions into your taxable accounts (the model assumes $2,000 a month, or $24,000 annually) and whether the additional contributions will make up the difference.

Let's assume you have $150,000 in retirement assets, such as 401(k) plans or IRA accounts, and $150,000 in taxable accounts. This model estimates what those sums will grow to over 20 years at different rates of return. There's a range for annual returns of 8% to 15%, our low and high estimates of growth in the S&P 500 index for the next 30 years. (The 23.8% average annual gains in the S&P 500 we've seen in the last five years are unlikely to be repeated in our lifetime.) We also reduce the return of the taxable assets by 2% annually to take into account the drag of taxes.

In the model, you'll see that you would need a nest egg of between $1,875,000 and $3,000,000 to provide income of $150,000 annually.

Software programs such as Microsoft Money or Intuit's Quicken will enable you to make more complex projections of your retirement picture, but this model gives you a quick-and-dirty overview.

What should you do if the model shows a shortfall under most scenarios? Do your very best to increase your savings rate. Most brokerages will enable you to sweep money automatically from your checking account and invest the proceeds in mutual funds of your choice. Pick well-rated funds with a good track record in both bull and bear markets, with no loads or commissions and low expense ratios. If you have a good five-year track record picking stocks (which means that your average after-tax returns are greater than that of the (VFINX Quote - Cramer on VFINX - Stock Picks)Vanguard 500 Index fund, then periodically liquidate the mutual fund in favor of individuals stocks (at least 30, preferably 40). If you keep your turnover low (no more than 20% annually in your taxable accounts) you will postpone paying capital gains taxes for an average of five years.

In summary: