Quickly Estimate How Much You'll Need For Retirement

(MoneyWatch)  Do you have any clue how much money you'll need to save for retirement? A recent survey by the Employee Benefit Research Institute indicates that most people don't.
In the 2009 EBRI Retirement Confidence Survey, only 44 percent of people said they had done some planning, and another 44 percent said they simply guess. That leads me to believe that most people have no idea how much they'll need.

One of the main reasons for the confusion is that people don't understand how much of a distribution they can take from their savings each year in retirement. If you don't know that number, then you can't even do the most basic calculation.

So here is a good rule of thumb: Expect distributions of about five percent each year from your retirement savings.

This means that if you want to live on $50,000 a year from your investments, you need $1 million. When the markets get tough, as they are now, you may have to drop the distribution to four percent to survive. But on average, five percent is a reasonable estimate.

The reason the starting distribution rate is so low is because of inflation. To keep up with inflation, the initial distribution needs to increase over the years. For example, what starts out as a $50,000 distribution at age 65 would need to grow to almost $105,000 after 25 years at three percent inflation.

If we had no inflation, then you could start with a higher distribution amount. But inflation is a reality of modern markets, and the pressure created by inflation means you have to start with a lower initial distribution.

Based on the five percent distribution rule, there is a quick calculation you can run to estimate how much you might need for retirement.

• First, pick an amount in today's dollars that you believe would allow you to live a comfortable retirement.
• Second, divide that number by 0.05. The result will give you an estimate in today's dollars of how much money you need to retire.

For instance, assume you want $60,000 from your investments in retirement. If you divide $60,000 by 0.05 ($60,000/0.05), you get $1.2 million. That's a good estimate of the savings needed to support your desired lifestyle.

How you get to that $1.2 million requires more assumptions about inflation, savings rates and investment returns. And I will cover some of those concepts in future posts.

Bottom line: Understanding the retirement income distribution rule will at least give you a ballpark number for how much you need to save for retirement.

Money photo from Flickr courtesy of beansoup 67, CC 2.0