Your Retirement Calculations May Be Way Off

If you have calculated how much money you will need for retirement, you are well ahead of the game. Only four in 10 workers have determined their retirement income needs, according to the Employee Benefit Research Institute (EBRI). But even if you have done the calculation and are working toward your savings goals, you're still not in the clear.

Many financial experts and online calculators will give you a quick "rule-of-thumb" estimate of how much of your income you will need to replace in retirement. For example, Jim Bell, president and founder of Bell Investments, recommends that, as a rough estimation, you calculate how much pretax income you will need to get through one year in retirement and then multiply that number by 20 so that you can draw 5 percent each year of retirement. He calls this the 20 times rule. Like many retirement rules of thumb, it is based on the average retiree.

However, the amount of money that Americans need for an adequate retirement can vary widely based on individual factors like your gender, retirement age, asset allocation, percentage of annuitization of wealth, and how you spend.

Retirees often need substantially more money than rule-of-thumb calculators estimate, according to Jack VanDerhei, an EBRI fellow. He cautions against using rule-of-thumb or online retirement tools that use average life expectancy or average rates of return to calculate how much money you will need in retirement.

"If all you use is averages that implicitly means that all you've done is save enough money so half the time you have enough for retirement and half the time you fall up short," says VanDerhei. Instead, he is developing a "building block" approach to retirement planning.

The three building blocks that EBRI says traditional retirement calculators don't factor in are:

1. Investment risk. This is how well your assets will perform during retirement. "Some years it can be very high and some years it comes up negative," says VanDerhei. You can lower this risk by investing less aggressively as your get older.

2. Longevity risk. This is how long you expect to live, which may or may not be different from the average life expectancy that is currently 82 for men and 85 for women.

3. Catastrophic healthcare costs. A medical emergency has the potential to wipe out your retirement savings. Healthcare costs can be affected by age, gender, geographic differences on healthcare costs, and Medicaid eligibility. "What happens if you need long-term care?" asks VanDerhei. "A lot of people know about Medicare. What they don't understand is what Medicare doesn't cover." VanDerhei recommends investing in long-term care insurance in addition to other health coverage.

EBRI has determined that no single number can capture the amount of preretirement income that a retiree will need. Instead, VanDerhei's model points out how much you need to save in order to have a 50 percent chance of an adequate retirement income, which is what most other rule-of-thumb calculators produce, but also tells you what you will need for a 75 percent and a 90 percent chance of a successful retirement. For example, a single male retiree making $40,450 or more a year would have to replace 52 percent of his income to have a 50 percent chance of an adequate retirement, but replace 119 percent of his income to have a 90 percent chance of having an adequate retirement.

"The results of this model reveal the sobering, if not staggering, amounts of money needed to provide a reasonably high chance of being able to afford retirement," VanDerhei says.

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