Millionaire Mommy Next Door » Calculators

Are You Saving Enough For Retirement? Use These 4 Simple Rules Of Thumb And Find Out Now.

Millionaire Mommy Next Door — Fri, 18 Sep 2009 18:00:16 +0000

This is a guest post written by Todd Tresidder.

How do you know if you are saving enough so you can afford to retire? And more importantly, are you saving enough to retire with confidence so that you can support your present lifestyle without running out of money early?

To answer these questions, you might consider using one of the many online retirement calculators available. Unfortunately, these “simple” retirement calculators are often complicated and require you to assume many things about your future retirement that may or may not work out to be true. It’s the old “garbage in equals garbage out” rule, and nowhere is that rule more true than with retirement calculations.

One alternative to sophisticated retirement calculators is to apply simple rules-of-thumb that allow you to quickly and easily estimate the sufficiency of your nest egg and savings plans. While these simple formulas lack the “rocket science” sophistication of Monte Carlo theory and other financial planning innovations, they do provide a reasonable ballpark approximation that is easy enough to do yourself – without a computer, software, calculator or financial planner. Usually, a pencil and the back of a cocktail napkin are sufficient.

The advantage of this simplicity is you will actually complete the exercise – which is essential to successful retirement planning. You must know the retirement savings goal you are aiming for in order to plan constructive actions to reach the goal. You are far better served by knowing a rough approximation of your retirement planning needs than to have no estimate at all.

The truth is perfection in retirement planning is impossible anyway because accuracy depends on assumptions about your future which can never be made with certainty. Therefore, it’s better to at least work with ballpark estimates than to risk being thwarted by complication that might keep you from playing the game altogether.

Below are four simple rules-of-thumb for retirement planning that will at least get you in the ballpark until you have the time and inclination to sharpen your pencil…

The Ten Percent Rule

Some old-wives-tales are true, and the importance of saving 10% of your income happens to be one of these truths. This retirement savings strategy was popularized in the bestselling book The Richest Man in Babylon. In general terms, the way the math works is if you save 10% and invest it with long term returns around 10%, your investment portfolio will grow to the point that it can support your lifestyle from earnings in roughly 35-40 years. That means you could retire and live on the investment earnings alone, never touching the principal. Your life expectancy doesn’t even matter in this situation because you would never run out of money since it doesn’t require you to spend principal. The biggest risk to this simple formula is inflation, although even with that limitation it still provides a good working approximation for how much you should be saving.

What’s fun about this formula is how easy it is to understand, easy to implement, and easily adapted to your situation. For example, if you have less than 40 years until retirement then you should obviously be saving significantly more than 10%. The sooner you start saving, the longer you have for your interest to compound to build your retirement fund. If your average investment return exceeds 10%, you won’t need to save as much. If it is less than 10%, you need to save more.

One big benefit to using this simple rule-of-thumb is you don’t need to pay for a fancy financial plan that sits in the binder on your shelf collecting dust to get started. It is a rough approximation that points a clear direction so you can get started immediately – and starting immediately is a critical factor to your retirement savings success.

The “Millionaire Next Door”

Now that we have a reasonable approximation for how much you should be saving each month, lets examine a different approach that provides an approximation for how successful your savings efforts have been to date.

According to The Millionaire Next Door, authors Stanley and Danko provide a simple yet reasonably accurate formula for assessing your wealth accumulation skills:

Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.

For example, if you are 35 years old and earn $100,000 per year with no inheritances, then your net worth should be $350,000: 35 times 100,000 divided by 10 equals 350,000. If you meet this standard, consider yourself to be “on track” for moderate wealth accumulation and a successful retirement fund. You aren’t a super achiever, but you aren’t behind either.

Go ahead and do the math for yourself. How do you measure up? This formula is really just another twist on the 10% savings rule cited earlier. It is based on sound mathematics and seems to provide a conservative but realistic figure for a broad range of scenarios.

Although it does not consider inflation, taxes and varying interest rates, this simple formula does yield a useful estimate of your retirement savings goal. It gives you a fast and easy way to see how well you are progressing toward financial freedom.

Stanley and Danko go one step further, creating two additional benchmarks based on their basic formula. “Prodigious accumulators of wealth,” or PAWs, have accumulated twice the savings indicated by the formula. “Under-accumulators of wealth,” or UAWs, have accumulated half the expected total. If you are a PAW then you are reasonably on track to knowing if you can afford to retire. If you are a UAW, now is the time to step up your financial management skills and start saving more.

12 Times Income

Jonathan Clements, former columnist for theWall Street Journal and author of The Little Book of Main Street Money: 21 Simple Truths that Help Real People Make Real Money, offered another alternative to the “How Much Money Do I Need To Retire?” question by claiming a reasonable retirement nest egg should be 12 times your income. To reach this goal, the amount you need to set aside each month depends on how much time you have before your target retirement age and your current savings-to-income ratio. This premise makes a few assumptions:

your income increases to match inflation,
you draw 5% of your savings as income the first few years of retirement, and
you achieve an investment return of 5% after inflation.

The numbers purport to yield 60% of your pre-retirement income. Combined with Social Security and other income, you might end up with 80%, a figure that most retirement calculators assume is enough. Alternatively, if your own calculations show that you need a higher percentage, then you need to amass more than 12 times your income.

Rule of 25

One of my favorite rules for simplifying how much is enough to retire is to multiply your expected annual spending for your first year of retirement by 25 to determine your total savings required. This is just a mathematical simplification of the famous 4% rule where you are allowed to spend 4% of your savings each year during retirement.

This rule is on firm empirical grounds because the sophisticated retirement planning models including Monte Carlo optimizations will generally result in spending rules ranging from 3-5% depending on assumptions and confidence interval required. Now you can get roughly the same result without a computer, software or arcane mathematics. Just take your first year of retirement spending, multiple it by 25, and presto – you are right in the same ballpark.

Summary

These quick and dirty rules of thumb are far from perfect. But the ugly truth about retirement planning is there is no such thing as perfect. In the end it is all a rough approximation anyway. For those readers wanting more explanation and detail, the ebook “How Much Is Enough To Retire” will help you understand exactly when you can afford to retire.

The future is unpredictable and conventional retirement planning requires you to predict the future in order to apply their models – this is a serious flaw. The truth is many unknowable factors will determine your financial needs during retirement, and those will only be known in the fullness of time. There are alternative models to retirement planning that don’t require you to see into the future and for those readers who don’t have the time or inclination to learn those models, this article provides some simple rules that will get you close enough for basic planning.

The important thing is to develop a concrete retirement savings goal to work toward – regardless of the model used. An inaccurate goal is better than no goal at all. You can use these simple rules of thumb to get started today and sharpen your pencil later when accuracy becomes more important.

About the Author

Todd R. Tresidder is a financial coach who retired comfortably when he was just 35 years young. His ebook, How Much is Enough to Retire? is based on his own experiences and explains how you, too, can afford to retire. Check out his web site for more retirement planning books, educational articles, and try his free retirement income calculators.

photo credit: ted.sali

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Get Real About the Difference Between Needs and Wants: Enjoy the Life You Really Want to Live!

Millionaire Mommy Next Door — Mon, 31 Aug 2009 02:19:15 +0000

Sally wants Mark to work more so she can quit her job to be a stay-at-home mom for their two young children. Mark wants Sally to continue working so they can pay down debt and build some savings. Despite earning a higher than average combined annual income, they often argue about money. Worse, they feel stuck, unable to do anything about their current financial situation.

This typical family lives in a four bedroom suburban home. Kids’ toys multiply like horny rabbits, spilling into the gigantic playroom. Two newer cars and a pickup truck occupy the three-car garage. The RV attempts camouflage behind a tall privacy fence that surrounds the expansive green lawn.

The children’s toys gather dust all week long because the kids are away at daycare, 50 hours a week, while Sally and Mark work. The big toys gather dust, too — the RV rarely leaves the yard because once the weekend arrives, the family feels too wiped out to go anywhere. At least the big screen HDTV LCD surround sound system sees some love while everyone veges out…

Mom and Dad tell me their number one priority is spending quality time with their two young children. But the children spend the majority of their awake hours with daycare providers because Mom and Dad have to work overtime to pay for and maintain their grand accumulation of Stuff.

Clearly Sally and Mark’s financial obligations are out of whack with their personal priorities.

The truth is they haven’t discovered the difference between their needs and wants. Once they do, they will find it IS possible to enjoy the life they want to live, together, with their children.

How to find the difference between needs and wants:

1. Imagine that you and your family are currently camped out in a homeless shelter, eating at the soup kitchen and receiving government assistance. Now imagine that you landed a job that earns just enough money to pay rent on a small apartment and to buy your own food. Add bus fare for your work commute. Write down your bare bones monthly costs. Here’s an example based on data collected for an average family in the lowest income bracket:

Food = $254
Shelter = $627
Clothing = $71
Transportation (public) = $12

Total Bare Bones BASIC NEEDS = $964 a month

2. Write down your actual expenses. Place these numbers next to the column you created in step number one above. Here’s an example using Sally and Mark’s actual expenses:

Food = $1,027 actual
Shelter = $2,400 actual
Clothing = $457 actual
Transportation (public) = $1,613 actual

Total ACTUAL EXPENSES = $5,497 a month

3. Subtract your bare bones needs from your actual expenses. The results are your basic wants.

Food = 1,027 – 254 need = $773 want
Shelter = 2,400 – 627 = $1,773 want
Clothing = 457 – 71 = $386 want
Transportation (public) = 1,613 – 12 = $1,601 want

Total BASIC WANTS = $4,533 a month

4. Similarly, separate the rest of your expenditures into needs and wants. Be brutally honest with yourself. Sally and Mark’s looks like this:

Kids Toys = $200 actual minus $15 need = $185 want
Gym Membership = $125 actual minus $0 need = $125 want
Tobacco/Alcohol = $123 actual minus $0 need = $123 want
RV = $250 actual minus $0 need = $250 want
Cable TV = $70 actual minus $0 need = $70 want
Day Care = $1,400 actual minus $0 need = $1,400 want

Total EXTRA WANTS = $2,153 a month

Results: If Sally and Mark reduce their material wants, they could save up to $6,686 a month — $80,232 annually — easily enough to afford one parent the option to quit their job, pull the kids out of daycare and raise them themselves. If their top priority is to spend more time with their children, clearly they can afford to do so.

I’m not advocating that you should get rid of all your wants, nor am I saying that every parent should quit their job to raise their children. That’s not what this post is about. I simply find it important to uncover the role needs and wants play in our financial life. My intention is that you realize your life is full of choices. Once you decide what is truly important to you and make a conscious choice, reaching your goal is simply a matter of putting your money where your mouth is.

BONUS! I’ve created a very unique tool that calculates the difference between your needs and wants. It also uses dollars, the value of your time, AND your personal values and priorities as currency! This is the spreadsheet I use to create my own spending plan (aka budget). You can use this spreadsheet online at Zoho (where it can act wonky at times!) or better yet, click here to download the Excel (.xls) file directly to your computer for immediate use. This spreadsheet works on my Mac in Numbers, too. You are welcome to share this spending plan tool with your friends or post it to your own blog.

I have a favor to ask: This post and the spreadsheet I designed took me considerable time to put together. If you like them, please share this post and/or spreadsheet with your friends, Digg, Twitter, Stumble Upon, Facebook, and other social media applications. Thanks!

Relevant Posts:

How To Revolutionize Your Spending Habits

How To Increase Your Financial Bliss

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photo credit: by Robert S. Donovan

How to Make a Million Dollars While Eating Lunch

Millionaire Mommy Next Door — Sun, 09 Aug 2009 22:01:39 +0000

In response to my last post, Would You Ditch A Car For $1,000,000?, a reader made the comment: “As a grad student in an urban area, I don’t have a car (nor could I afford one) and I use public transit. … I wish there was a “big ticket” item like that that I could easily cut out of my life, but there just isn’t. Instead I try to cut back on small things and aggressively invest for cashflow.”

While savings do accumulate faster when you cut back on the biggest budget-buster categories (housing, transportation, insurance and taxes), the little things do add up. Take for instance:

My Million Dollar Lunch Recipe

Replace your $9.50 restaurant lunches (sandwich, fries, soft drink, sales tax, tip and mileage) with a nutritious $3.00 lunch brought from home.
Deposit your $143 monthly savings ($6.50 daily, 22 working days a month) into a Roth IRA retirement account.
Invest in equities (stocks, mutual funds) at a 10%* annual long-term average rate of return.
Let your account simmer for 41 years.

Recipe Yield = $1,000,837

Serve: During retirement with whipped cream and a cherry on top.

Ingredients:
Total deposits = $70,356
Total interest earned = $930,481
Total taxes paid = $0
Total Saved= $1,000,837

Optional Garnishes:

Combine with a 20 minute walk to the park for lunch.

Yield: 1,277,232 calories– enough to keep off (or lose) 365 pounds! (Calculated for a person weighing 140 pounds walking 4mph for 20 minutes (1.33 miles) 5 days a week for 41 years.)
Pack a lunch for your spouse.

Yield: An additional $1,000,837
Add a group of supportive friends for lunch to work on the Baby Steps to Financial Freedom together. Yield: Financial freedom – with friends who will have the resources to enjoy it with you!

Isn’t it amazing how much money you can amass by investing small amounts over long periods of time?

Once you think in terms of investing instead of spending, look for ways to duplicate this process in other ways. Consider the following actions:

buy staples in bulk and invest your savings
invest your employee bonuses
invest unexpected financial gifts and inheritances
invest your tax refunds
buy a term life insurance policy instead of a whole life one and invest your monthly premium savings
buy a used car instead of new and invest the difference in price
borrow books, movies and music from your local public library and invest your savings
save and invest your pocket change

Imagine this: Starting with $0 and depositing $5,000 annually in a Roth IRA account over 41 years (at a 10%* annual rate of return compounded monthly), you will have $3,081,554.

Ingredients:
Total deposits = $210,000
Total interest earned = $2,871,554
Total taxes paid = $0
Total Saved= $3,081,554

Choose affordable and cost-effective options and rather than feel deprived, feel excited that you get to invest the difference in yourself and your future.

~ Bon Appetit!

ooOOOoo

*The actual rate of return is largely dependent on the type of investments you select. From January 1970 to December 2008, the average annual compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 9.7% (source: www.standardandpoors.com).

Total savings are calculated in actual dollars (not inflation-adjusted). A common measure of inflation in the U.S. is the Consumer Price Index (CPI), which has a long-term average of 3.1% annually, from 1925 through 2008.