How Much to Save for Retirement? A lecture for FIN 352 Professor James Dow CSUN (draft)

The Lecture How much do I need to save for retirement? We will cover: – How to make a simple calculation. – What makes the calculation more complicated in practice.

Timeline of Wealth Now End of Life Date of Retirement Add money each year Withdraw money each year Wealth

A Three-Step Calculation 1) How much money do you need to withdraw from your savings each year when you are retired? 2) How much wealth you need at retirement? 3) How much do you need to save each year to accumulate that wealth?

A Word About Inflation Inflation will reduce the value of your savings over time. To adjust for inflation, we will: – Use current dollars for calculations. – Use inflation-adjusted rates of return.

A Word About Uncertainty A number of uncertainties – Our expenses when retired. – The return on our investments. – The rate of inflation in the future. – How long we live. In our simple calculation, we will assume that everything is known for sure. At the end of the lecture, we will look at how to incorporate uncertainty. The calculation of how much we need to save must be repeated each year to reflect what we’ve learned over the previous year.

1) How much income per year? Start with your current income. Subtract the amount that comes from social security or a pension. This equals the amount that you need to generate each year from savings.

2)How much wealth does this require? A number of different ways to do this: – Find wealth needed to generate income if no uncertainty. – “Monte Carlo” analysis. – 4% Rule

3) How much will you have to save? Two interconnected decisions – The amount you save each year. – The asset allocation decision which determines your expected rate of return.

A Simple Example George is a 40 year old single man. He plans on retiring at 65 and he expects to live for another 20 years. He has no current savings.

1) How much each year? He makes $60,000 per year and believes he can live on 80% of that when retired. – 0.8*$60,000 = $48,000 needed income From social security and his pension he expects to get $25,000 per year. – $48,000 - $25,000 = $23,000 from savings

2) How Much Wealth at Retirement Assume that his savings after retirement earn 3% (after inflation). Wealth at retirement should equal the present value of all the payments made in retirement. PMT=$23,000; I=3; N=20; FV=0 PV = $342,182

3) How much to save How much must he put aside each year for the next 25 years? Assume that his savings before retirement earn 5% (after inflation). FV = $342,182; I = 5; N = 25; PV = 0 PMT = $7,170

What if he can’t save that much Start saving earlier Retire later Live on less during retirement Invest more aggressively

Some Other Complications Already has money saved. Money in different accounts earn different rates. Couples. Bequests.

Dealing with Uncertainty Inflation Rates of Return Expenses Life Expectancy

The 4% rule Pull out 4% of your savings each year. If your savings earn 4%, you can withdraw the same amount of money indefinitely. $23,000/0.04 = $575,000 $312,578 if you plan to exhaust your savings in 20 years.

Insuring Medical and Disability Insurance Pay off mortgage before retirement Annuities.

Conclusion It’s important to plan for your retirement needs. Because of the uncertainties, you can’t know exactly how things will turn out. You can see if you’re on the right track.