A 6-Step Guide to Figuring Out When You Can Afford to Retire

How do you know when you can afford to retire? That's the big question most people ask as they approach their retirement years. The best answer: when you've done the math and the numbers work out. The trouble is, most people just guess at how much money they need to retire -- and they usually guess way too low.

Welcome to the final week of my series, 12 Weeks to Plan Your Retirement. If you've followed the first 11 weeks, you've done a lot of homework. Now it's time to put it all together and crunch the numbers to see if your retirement income will cover your living expenses for the rest of your life, no matter how long you live and no matter what happens in the economy. It's a tall order, but nevertheless, that's what you need to do.

Let's start by planning how you'll balance the magic formula for retirement security:

I > E

Income > Expenses

To get started, you'll need to choose the age at which you want to retire, taking into account your life expectancy and what you hope to do in retirement, as discussed in week one of this series. You'll also need to consider your spouse's life expectancy, if you're married.

Now it's time to see how your projected income measures up to your projected expenses at your desired retirement age. After you do the math, if your retirement income falls below your expenses, you'll need to make some adjustments and keep crunching the numbers until you've determined when you can really afford to retire. You may need the assistance of a professional financial advisor to get it all figured out, as I discussed in week two of this series.

The first three steps in estimating your retirement income involve adding up three things -- your retirement income from Social Security; the income you generate from your IRAs, 401(k), and other retirement savings; and your pension income, if you've earned this type of benefit. Estimating your living expenses is the fourth step. Make sure you've provided for your spouse or partner after you're gone -- that's the fifth step. And the sixth and final step involves the inevitable bargaining and negotiating with yourself to make the numbers work. Most likely that will involve continuing to work and/or taking a close look at your living expenses to see how you can shave them in order to be able to afford to retire.

When estimating your retirement income and expenses, you might want to use an online retirement calculator. Alternatively, you may want to use your own spreadsheet or work with a professional retirement planner.

First, let's address each source of income, starting with Social Security. The buttons to move to the next page follow the links below.

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Step 1: Estimate Social Security Income

As described in week five of this series, you'll need to decide the age you want to start receiving Social Security benefits and then estimate the amount of your monthly income at that age. If you're married, you and your spouse will need to decide when to start your spouse's income and estimate how much it will be as well.

You might decide to start your Social Security income and/or your spouse's income at a date later than your desired retirement age. (See my post from week five for reasons why you might do this.) If you decide to do this, you'll need other sources of income to replace the Social Security benefits you're deferring. You might need to work part time to fill this gap or draw additional amounts from your retirement savings.

Now it's time to determine how much income you'll generate from your IRAs, 401(k), and other retirement savings.

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Step 2: Determine Income from Your Retirement Savings

You'll need to estimate the amount of retirement income your IRAs, 401(k), and other retirement savings vehicles will generate for you. To do this, you'll first have to determine the total amount of your retirement savings from which you'll be generating retirement income.

Start with the inventory of your retirement savings from all sources, as described in week four of this series. Then you'll need to make some adjustments:

If you anticipate that you'll sell your house and realize a profit, and you want to use these gains to generate retirement income, add to your retirement savings the gain you expect to realize, after considering taxes and sales expenses.

Subtract from your retirement savings any investment accounts you'll dedicate to paying for long-term care expenses, as described in week eleven of this series.

Subtract from your retirement savings the estimated total amounts you need to make up for any Social Security income that you defer, as described in the previous step.

Subtract any amounts that you plan to set aside for unforeseen emergencies.

If you expect a lump sum payment from a pension plan, add this amount to your retirement savings (see the next page for details).

Add any amounts that you expect to save between now and your desired retirement age.

Add any expected growth in your investments that you expect between now and your desired retirement age. If your desired retirement age is less than five years from now, I prefer to assume you won't realize any future growth. This is just to be safe, given the current low interest rates and the volatility in stock investments. If you want to assume you'll have future investment earnings, however, make sure the growth rate you use is realistic given the types of investments you use. And use more than one assumed rate of return to see the range of possibilities -- a pessimistic rate, an expected rate, and an optimistic rate.

Now you've got the total amount of retirement savings that you'll use to generate the retirement income you'll need to cover your living expenses.

Next, you'll need to select one of three methods -- or a combination of the methods -- to generate lifetime income from retirement savings. (I described these methods in week six.) Once you've done this, estimate how much income you'll receive under the method or methods that make sense for you. The amount of retirement income your savings can generate will vary widely, depending on the method you use.

This points to a common flaw with most online retirement planning calculators: They won't let you specify the method you want to use to generate retirement income from retirement savings. In fact, many calculators choose the method for you or assume you'll draw as much as needed to meet your living expenses.

Here's one way around this flaw: Many calculators let you input "other" sources of retirement income. In this case, you can estimate the amount of income you expect to receive from your retirement savings and then input this amount into the "other" category.

Once you've run the numbers, if you find you don't generate the amount of income you need, you might want to revisit your choice of method for generating retirement income, and then do the math again.

Next we'll determine how much you'll get from traditional pensions. You can skip this step if you know you haven't earned a pension benefit from your employer and move on to step four, estimating your retirement living expenses.

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Step 3: Calculate Your Income From Traditional Pensions
If you've participated in a traditional pension plan, you'll want to get estimates of your monthly income at your desired retirement date. You can do this either through an online pension estimator provided by your plan's administrator, or by asking your HR department.

If you're married or have a life partner, make sure you get estimates for a joint and survivor annuity. I prefer 100 percent, 75 percent, or 66-2/3 percent survivor annuities, which continue these percentages of your initial retirement income to your spouse after your death. I would probably avoid 50 percent joint and survivor annuities, simply because the living expenses for one person are usually much more than 50 percent of the living expenses for two people.

You might be eligible for a lump sum payment instead of a lifetime monthly income. Normally I prefer drawing a monthly retirement income, since you don't know how long you'll live. (I've described the pros and cons of a lump sum election in prior posts.) If you take the lump sum, then you'll need to add the lump sum to your total retirement savings when determining how to generate retirement income, as discussed in the previous step.

Now that you've estimated your three sources of retirement income, you're ready to estimate your living expenses.

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Step 4. Estimate Your Retirement Living Expenses

You'll want to add up all your retirement living expenses -- your regular monthly living expenses, plus any expenses you don't pay on a monthly basis, such as insurance premiums, taxes, and gifts. Include your housing expenses, as discussed in week nine, your costs for medical insurance premiums and out-of-pocket expenses, as discussed in week ten, and any premiums for long term care insurance, as discussed in week eleven.

It's inevitable that your living expenses will change throughout your retirement. For example, at some point you might pay off the mortgage on your house. And your medical expenses will be different before and after age 65, the eligibility age for Medicare.

Some people also think they'll spend more money in their early years of retirement, when they're active and more likely to travel. That could be, but your living expenses could also increase in your later years, as you incur more costs for medical and long term care.

If you feel that your living expenses might change significantly during your retirement, you might want to factor that into your retirement planning. Some retirement planning calculators let you estimate how your expenses will change in retirement, or they might allow you to separately identify required living expenses vs. discretionary expenses.

And of course, you can expect that many of your living costs will increase for inflation. The best way to address inflation is to make sure your sources of retirement income increase for inflation as well. Social Security is already indexed for inflation, which is one important reason you should maximize your Social Security income. In addition, I recommend that you set up the income you'll receive from your retirement savings so this income will increase for inflation as well.

Most traditional pensions aren't increased for inflation; if you'll have significant income from a fixed pension, one way to address inflation is to spend just 75 percent of your pension income during your first year of retirement. Then invest the remainder in a special inflation reserve account. In the second year, increase the amount you spend from your pension by two to three percent to account for inflation, and invest the remainder in your inflation account. Continue doing this until you're spending your entire pension; then each year thereafter, start drawing from your inflation reserve to make up for inflation.

Managing your living expenses is the most common technique people use to be able to retire, as I discussed in week eight in this series. This is one way to make adjustments in your situation to make the numbers work. The bottom line: You should focus on buying only what you truly need and what truly makes you happy.

Now it's time to consider your spouse or partner in your planning. You can skip this step if this doesn't apply to you.

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Step 5: Take Your Spouse or Partner Into Account

If you're married or in a serious commitment, you'll need to consider your spouse or partner in your retirement planning. Married women can expect to have a period of widowhood of five to ten years at the end of their lives, since men tend to marry women who are a few years younger and women typically outlive men by a few years. It's critical that you consider this inevitable situation when planning for retirement.

All the decisions and calculations that you made in the previous steps will be impacted by the steps you take when considering your spouse or partner, such as:

Where you'll live and what you hope to do when you're retired
When to start Social Security
How to use your retirement savings to generate retirement income
The form of payment you elect for a traditional pension, if that applies to you
Your strategy to address long term care expenses
Your estimated living expenses, including housing and medical expenses

It's best to involve your spouse or partner in your planning, so that he or she can provide input and be familiar with the plans. And when it comes to planning, two heads are better than one!

Finally, you're ready for the inevitable: Bargaining with yourself to make the numbers work.

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Step 6: How to Make the Numbers Work

It's often the case that the first time you go through these steps, your income won't quite cover your projected expenses, so you'll need to make some adjustments and do the math again. Here are some common strategies -- while easier said than done, these are nevertheless things you can control:

Retire later
Work part time
Fine-tune your living expenses
Share housing to dramatically reduce your living expenses
Move to a cheaper part of the country
Use a different method of generating retirement income from your retirement savings

All of the above is a lot of work, but it's well worth the effort. The people who do best in retirement are those who planned for it. Remember, you're planning for a period of your life that can last 20, 30, even 40 years. It's inevitable that it will take a lot of time to do your homework and do the math to come up with a plan that works for you.

Good luck!

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Steve Vernon

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 Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.

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