When it comes to retirement planning, many of us look at things in terms of building wealth in a way that results in a huge nest egg. The reason behind this, of course, is to attempt to create a situation in which you have a large enough nest egg that, once you move it into less risky investments, you can live mainly on the interest it produces, withdrawing only a small amount of principal each year. With a large enough nest egg, you are supposed to be able to make your money last indefinitely, even after the ravages of taxes and inflation take their toll on your real returns.
While saving up to build a nest egg in a tax-advantaged retirement account (such as a 401k or an IRA) is an important part of building for the future, you might not know how much money you will need in your nest egg to make it work. Additionally, you can help your future by cultivating multiple income streams so that you are relying on more than just what comes from your accumulated nest egg.
Estimate Your Monthly Income Needs
The first thing you need to do is figure out what your monthly income needs will be. You can do this using your current income needs as a starting point. Look at your currently monthly expenses. Some of these expenses might disappear by the time you retire. Indeed, if you will have your home paid off by the time you retire, a monthly mortgage payment may no longer be an issue. (You might want to keep it in your calculations, though; you might decide to travel or spend money on some other hobby.) Some suggest that you will need about 70% of your monthly income in retirement. I like to base my estimates on my expected monthly expenses, though. This can give me a general idea of my likely income needs.
Using 100% of your current monthly expenses as a basis for your estimate can also be useful, since it’s better to overestimate your needs, rather than underestimate them. If you plan to adopt an expensive hobby, travel, or if you are worried about rising health care costs, you can consider adding expenses on top of what you already pay now. If you plan to downsize your lifestyle, and sell many of your belongings, you can reduce your estimated retirement expenses in relation to your current expenses.
Now that you have an estimate of your monthly expenses, you can use that to determine your monthly retirement income needs, and figure out a plan to meet them.
Building Your Nest Egg
If you estimate that you need $4,000 a month in income, that’s $48,000 a year. If you assume 4% interest yield on your nest egg, you will need $1.2 million in your nest egg to provide you with enough to live on. You can use various retirement and compound interest calculators to determine how much you need to set aside in order to reach that amount. If you put $1,000 a month in your retirement account for 30 years, and you average 6% a year (compounded annually for simplicity in this example) you will wind up with a little more than $1 million. You will just come up short. You will have to either use some of your principal each year, or scale back your expectations.
Another issue with relying on the size of your nest egg to fund your retirement is that you never know what might happen. Will your retirement portfolio yield an average of at least 6% a year? What if a market crash occurs just before you retire? What if you move your assets into bonds and CDs, and they don’t offer 4% each year? And, of course, what if you didn’t start building your nest egg early enough, and you don’t have 30 years to accumulate the wealth you need.
Developing Revenue Streams to Meet Your Retirement Income Needs
What if, instead of $1.2 million, you will only have $800,000 in your retirement account by the time you retire. If you live of 4% of it, that amounts to $32,000 a year -- $2,667 a month. That leaves you $1,333 short each month. Now is the time to start developing revenue streams that might be able to help you close the gap. Social Security might be able to close the gap (if you think it will be viable when you retire), but with decreasing benefits, and the possibility that you retire before you can take full benefits you can take matters into your own hands.
You can start now to work toward creating an income stream to supply the shortfall. Dividend stocks, web site monetization, staring a business, or earning royalties from a creative work are all ways that you can develop extra income streams. These things, though, don’t just spring into being without effort. It can take years to build income streams. Many people spend a decade or two building income portfolios, carefully investing in dividend stocks, bonds and CDs, and then reinvesting the earnings. It is conceivable that such a strategy could result in an income that could help you close your monthly income gap.
Some even take on side jobs, part-time jobs and do odd jobs to earn extra money for a few years, and use that money to fund an income portfolio, or build up a retirement account. Developing alternative income streams, though, has the added benefit of being able to supplement for a time if your tax-advantaged retirement account has been hit by a market crash. Having an outside income stream can help cushion the blow. Even though your underlying investments may suffer losses, an income portfolio with cash, bonds and dividends will still supply you with a stream of income (although it may eventually be reduced somewhat) while your nest egg recovers.
Building a nest egg to help support you in the lifestyle you want in retirement is important, but you don’t have to rely only on that. Break your goal down into a monthly income goal, and develop a multi-pronged approach for reaching your desired monthly income.