Crunching numbers won’t crush you

It’s not fun, but can be done without pain

In the scheme of things, it’s nothing more than a math problem. But trying to figure out how much you need to fund retirement can be a complicated affair, especially when you factor in all thing things that could go wrong in your golden years.

There are at least three methods that you can use to get a sense of whether you’re on track or not, says Anna Rappaport, president of a Chicago- based consulting firm.

The first, and perhaps the best method, is what’s called a cash- flow analysis, a practice commonly used by financial planners. “A detailed, personalized cash- flow forecast is the best way for individuals to prepare and manage their retirement needs,” says Rappaport, co- author of a Society of Actuaries’ study, “Measures of Benefit Adequacy: Which, Why, for Whom and How Much.”

With the cash- flow analysis method, calculate what your annual expenses will be and multiply it by the number of years you need to fund. If you have enough income to fund those expenses, you’re in good shape.

You’ll need to estimate not only the cost of housing, health care, food and transportation, but the cost of discretionary expenses such as travel, gifts and the like. Plus, figuring out how many years of retirement you need to fund might require the help of an actuary. The worst case is not pretty: If you underestimate how long you’ll live, for instance, your standard of living in retirement won’t be the one you planned.

“For many of pre- retirees today, under- saving could be a very serious problem, but over- saving would not,” said Christine Fahlund, Ph. D., CFP, a vice president and senior financial planner at T. Rowe Price. “For retirees who eventually find themselves fortunate enough to have more money than needed to cover any catastrophic expenses, it wouldn’t be difficult to find ways to spend it or give it away to others in need.”

Experts have devised general rules that take some pain out of having to crunch numbers. But these rules, which can provide a starting point, are not without their shortcomings.

Many experts refer to the Aon/ Georgia State Replacement Rate research, which suggests that you try to replace 85% of pre- retirement income, a third of which is from Social Security. That replacement- rate ratio reflects how your expenses change as you move from work to retirement, according to the 2012 version of Aon’s study. For instance, you won’t be paying as much for work- related expenses or as much in federal and state taxes. But the replacement ratio factors in the possibility that you might travel more or might need to pay more for health care costs.

Rappaport says the income- replacement ratio is typically used by employers when designing plans and comparing their plans with other companies. It’s also built into many retirement- plan software programs.

But this rule has drawbacks. For one, your income- replacement rate will — in general — be different depending on your pre- retirement income, according to research from Dimensional Fund Advisors, an Austin- based mutual fund firm. It could range anywhere from 58% if you have household income of $ 86,882 or more, to 82% if you have household income of less than $ 25,870.

What’s more, Rappaport said the income- replacement ratio is not a good measure for individuals to understand how they will ultimately fare in retirement. It’s based on the law of large numbers, and you need to base your income- replacement ratio on one number — yours.

According to Rappaport’s paper, the best strategies to preserve assets without factoring in shocks may no longer be best, once loss of a job, divorce, illness and death are considered. “Making retirement decisions based on averages increases the risk of running out of money,” she says.

Another way to figure out how much you might need in retirement is to use the minimum needs measure. This method, generally used by policymakers, uses the Elder Economic Security Index ( EESI) to outline national averages for minimum needs for various household types and specific geographic areas.

This measure can help individuals understand whether what they have will support a minimum standard of living, Rappaport says. If expenses are much higher than the EESI standard, there should be opportunities for expense reduction. If resources don’t meet the EESI standard, an individual can’t afford to retire without significant financial deprivation.

Ultimately, however, Rappaport wrote that there is no “one- size- fitsall” measure of benefit adequacy, and there are many “moving parts,” depending on the purpose and the stakeholder using it. Individuals need to be aware that attempts to oversimplify the retirement- planning process can be very dangerous if used for personal decision- making.