With retirement calculations, the more information you have, the more accurate the estimate would be. Before you begin a calculation, ensure that you provide the following information:
a) Likely retirement age
b) Current income
c) Annual salary increase
d) Current age
e) Current pension plans and future pension benefits
f) Target percentage of pre-retirement income that you desire.
With this information, you need to perform the following steps in sequence:
i) Determine your pre-retirement income
ii) Calculate your desired retirement income amount
iii) Subtract other state benefits or defined benefits
iv) Work out the lumpsum needed
v) Assess your current retirement savings and project future values
vi) Deduct your projected savings to estimate the shortfall
vii) Calculate what needs to be done to eliminate the shortfall
i) You do not have to be clairvoyant to evaluate your pre-retirement income. Simply use an arithmetic progression (a to the power of n multiplied by current annual income), where a is the common ratio and n is the number of years to retirement. The common ratio is derived from the salary increase. If your annual salary increase is 4%, the common ratio will be 1.04.
ii) Your desired retirement income would be based on your pre-retirement income. The recommended target percentage would be at least 80%. If you’re currently earning $50,000.00 annually and your pre-retirement income is $120,000.00, your nominal target should be $100,000.00.
iii) You may be entitled to pension benefits from Social Security and employer’s defined benefits that would provide additional retirement income. The annual amount should be subtracted from your desired annual retirement income. This should yield a shortfall.
iv) The lumpsum needed would be the shortfall evaluated in step iii. To determine the lumpsum you require to meet your income target, you need to divide your shortfall by an average long-term interest rate. If your shortfall is $100,000.00 and the long term interest rate is 10%, the lumpsum needed would be $1,000,000.00.
v) You need to identify your current retirement savings plans, investments or annuities and use a financial calculator to project what the values of these funds would be at retirement. You would then tally the projected future values of all your plans.
vi) If your lumpsum needed exceeds the future values of your retirement plans, you have a shortfall. If not, then you would be on track.
vii) Once the shortfall is ascertained, use a financial calculator to determine the contributions that you need to make to eliminate the shortfall in a given investment vehicle.
The aforementioned process is the basic retirement calculation. Some retirement applications may be more flexible and allow you to simulate mutual fund performance. However, only a rough estimate is needed. The usefulness of this method is that it allows for a greater degree of transparency in calculations. Some needs estimators are vague and obscure. This calculation method would usually provide a more representative estimate.