In my last column, I showed you how to calculate the cost of and plan for the accomplishment of your financial goals, including help children/grandchildren with their college expense. In this column, we will discuss the process of successfully building your retirement fund.
Determining today’s cost of building a retirement fund is far more complicated than determining today’s cost of a college fund. This is because it is crucial that you calculate the ongoing effects of inflation into and through retirement in order to guarantee the development of a successful, secure retirement. Below I will attempt to give you the basic tools to do this for yourself.
Building an accurate retirement plan normally requires complicated algorithms that require a computer. If you find the process described below too complicated, or wish to be able to model different inflation and invest yield scenarios, I have made my personalized financial planning software available here.
If you build a retirement nest egg that provides just enough interest income to meet your needs in the first year of your retirement, you would not have anything left over to invest in order to offset future inflation after that. Therefore, based on the Rule of 72, discuss in a past column, 14 and a half years into retirement, assuming inflation ran at 5 percent average, your standard of living will be cut in half.
The two charts below will give you an idea of how much you need to set aside each month to build a retirement fund that will provide you with enough income to offset the effects of inflation. It was developed a number of years ago by the accounting firm of Coopers & Lybrand and appeared in U.S. News and World Report, but it is still one of the best tools I have seen without computer software to develop a retirement plan. Please note that this chart assumes an inflation rate of 4 percent, so if you want to project something different, you will need to use the type of financial planning software discussed above.
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Can you afford your goals?
Between this and last week’s columns, you now know the cost of each of your financial goals, including a college fund and retirement. You have broken them down to monthly payments you can start making today to ensure their accomplishment. However, one question remains: Can you afford the payments? Because if you do not pay for future goals like retirement and children’s college, they will be forfeited just like if you stop paying the payment on your home or car loans.
To find out, go back to your budget (covered in this column) and plug in these new expenses for you long-term goals. Do not be alarmed if this gives you a negative cash flow, as this is common. The reason is that you have added new burdens on your budget that are very necessary. If you find this to be the case, below you will discover where to find the extra money to meet your goals.
Curing a negative cash flow
There are three steps to reversing a negative cash flow:
1) Re-evaluate any advance payment schedules you have set up for your debts.
2) Cut your insurance costs.
3) Use “The Back-down Compromise” option.
I will discuss No. 1 above in the remainder this column, and address No. 2 and No. 3 in next week’s column.
Reevaluation of advance payment schedules
Many of us have been taught that it is best to pay off debts as soon as possible. That is good advice if you have high-interest credit card debts, or you have enough money to invest for your future and can still accelerate the payoff of your debt. However, in many cases, especially if you are making accelerated payments on your home or car and that is causing a negative cash flow, it is not such a good idea.
Do you remember our earlier discussion in this previous column about the importance of time? It is crucial that you start setting aside money for your goals today. Accelerating debt payments to the point where you do not have enough money left over for your goal payments is not a good idea.
If you are trying to pay off your home or car early and you have a negative cash flow, going back to the original schedule will free up money for your other goals.
In next week’s column we will explore how to use No. 2 and No. 3 above to cure the remainder of your negative cash flow.