What's your retirement number?

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(MoneyWatch) How much retirement savings do you really need in order to leave the workforce for good? Have you taken the time to figure it out for yourself?

If you're considering retiring soon, this is an important task you shouldn't do casually -- and you should never accept a general fixed number that you might have read is the goal for most people. Instead, you should calculate the retirement savings you need, taking into account your own circumstances and preferences.

There's been a lot of press about what your ideal "retirement number" should be, so let's see how you can estimate that number using the retirement scorecard series we published this week.

Retirement income scorecard: Interest and dividends
Retirement income scorecard: Managed payouts
Retirement income scorecard: Immediate annuities

You'll need to take three preliminary steps before you get to the fourth and final step -- calculating your retirement number. Below I've described all four steps and included an example -- a married couple, both the same age, who are considering retirement at age 65 -- to help you understand each of these steps.

Step #1: Determine how large a retirement paycheck you really need

The first thing you need to do is to estimate what your annual living expenses will be in retirement. After you retire, this number could differ dramatically from your current annual living expenses, because your personal and financial circumstances could change. For example, your living expenses may decrease in retirement if:

- You no longer have children living with you
- You're no longer saving for retirement
- You don't pay FICA taxes, and your income taxes are reduced
- You don't have any work-related expenses
- You're spending less on transportation, possibly owning just one car or using public transportation more often
- You pay off the mortgage on your house, downsize to a smaller residence, or move to a less expensive part of the country

On the other hand, your living expenses may increase if:

- You're paying more for health care or health insurance, or anticipate a need to pay for long-term care, which you'll have to start saving for
- You have dependent parents who need long-term care (and your financial help)
- You're traveling more or are participating in additional recreational activities and hobbies
- You spoil your grandchildren with trips or expensive gifts, or even help out with college expenses.

It's helpful to distinguish between your essential living expenses, which include such items as rent, mortgage payments, utilities, food, insurance, and property taxes, and your discretionary expenses for things like vacations, hobbies, and eating out. Because you don't know exactly how much money you'll be spending on discretionary expenses, you'll have to estimate this figure as best as you can. Be sure to include routine monthly expenses and expenses that are paid less frequently, such as property taxes and homeowners insurance, when you're calculating your essential living expenses.

You can estimate your retirement expenses with online software, such as Fidelity's Retirement Income Planner or Quicken. You can also find worksheets to help you in the Resources section of my website www.restoflife.com.

For the purpose of this example, let's assume that the married couple estimated their annual retirement living expenses at $50,000, including income taxes.

Step #2: Estimate your other sources of retirement income.

It's a good idea to understand how much annual lifetime retirement income you can expect from sources other than your retirement savings, such as Social Security or a work-related pension (if you're lucky enough to participate in such a plan).

You can get estimates of your Social Security income, based on your wage history, at the government's Social Security website. The site will show what your benefits income would be at various starting ages. For instance, you'll increase your income if you delay starting benefits beyond age 62, the earliest possible age you can start benefits. If you're married or in a committed relationship, also be sure to calculate the income your spouse or partner will be receiving.

If you participate in a defined benefit pension plan at work, you may also receive a significant retirement paycheck that's guaranteed to last for the rest of your life. You'll want to get an estimate of what this paycheck amount will be. Many employers have online retirement planning websites that let you estimate the amount of your pension at various starting ages. You can also get this information by calling your plan administrator.

Don't forget to include other sources of income that may continue in retirement, such as rental income or alimony payments. Then add up all your sources of retirement income, and subtract this amount from the estimate of your retirement expenses. The remainder is the amount you need to generate from your retirement savings -- your retirement paycheck.

For purposes of our example, let's assume the couple's annual Social Security income will be $24,000, factoring in both of their incomes (That is close to the average for people this age, according to the Social Security Administration.) Let's also assume this couple won't be receiving a retirement paycheck from a traditional, employer-sponsored pension plan.

Subtract the $24,000 in Social Security income from the couple's retirement budget of $50,000 and you'll see they'll need to generate a $26,000 annual retirement paycheck from their retirement savings.

Step #3: Decide which method or methods you'll use to generate a retirement paycheck.

As we've seen from my retirement income scorecard series, the various methods of generating a retirement paycheck produce different amounts of income. So it's only natural that your decision regarding which method to use will dictate exactly how much retirement savings you'll need to generate from that paycheck.

Choose a method, or a combination of methods, based on what works best for your circumstances, and then determine the payout rate. This rate is the amount of annual retirement income that can be generated by $100,000 in savings, and is shown in the retirement income scorecard series.

For our example, let's assume the couple decides to split their retirement savings 50/50 between an inflation-adjusted annuity and managed payouts with a four-percent withdrawal rate. Along with Social Security, this gives them a total retirement income that increases for inflation. The Social Security income and the annuity income are both guaranteed to last the rest of their lives, while the income from managed payouts only may last for life, although it's not guaranteed.

In this case, our couple's combined payout rate would be the average between the two payout rates shown in the retirement income scorecard series. The payout rate for the inflation-adjusted annuity is 3.9 percent; if you average this rate with the 4 percent payout rate for managed payouts, you'll have a combined payout rate of 3.95 percent.

Step #4: Estimate your number.

Finally, you're ready to calculate your retirement number! To do this, you'll want to invert your payout rate. (For those of you who forgot your high school algebra, just divide the number "1" by your payout rate.) In this example, that would be 1/.0395 = 25.32.

Then multiply this factor by the results you got in Step 2 -- the amount of annual retirement income you need to generate from your retirement living expenses. In this example, you would multiply $26,000 by 25.32, for a result of $658,320. That's the "number" in this example -- the amount of retirement savings this couple needs to have on hand in order to retire.

Keep in mind, you'll want to have a reserve for emergencies and other large expenditures, such as deductibles for medical expenses, long-term care expenses, replacement for cars, and large household items. This reserve should be separate and in addition to the savings you need to generate your retirement paycheck. You'll want to pad the number by at least a few $10,000. Adding in an emergency reserve could bring this couple's total retirement number to $700,000.

The resulting "retirement number" in this example is well above the average retirement savings of many Americans who are currently in their mid-60s. If this couple's savings are below this amount, they'll need to consider some alternatives, such as working longer or reducing their expected discretionary living expenses.

While calculating your retirement number may seem like a lot of effort, it's much better than just guessing. Most people guess too low, with the unfortunate result that they'll run out of money before they pass away. You'll be glad you made the effort to estimate how much retirement savings you really need when you reach your 80s and 90s, and your retirement paycheck keeps rolling in.

  • Steve Vernon On Twitter»

    View all articles by Steve Vernon on CBS MoneyWatch»
    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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