Thursday, July 25, 2013

Calculating Retirement Income and Fees from a 401(k) Account

By Tim Dulaney, PhD and Tim Husson, PhD

Saving for retirement means asking a lot of questions.

What monthly income will you need? Forbes claims this is the fundamental question that is often overlooked by 401(k) account holders.
“The lump sum in your 401(k) may seem like a lot, but when you translate it into a monthly income stream over 20 or 30 years, it may not be as much as you think,” [Jeanne Thompson of Fidelity] says. “Breaking it down into how much the money will provide will give you a much better picture of how much you’ll have to spend in retirement.”
Another important question is, how much of your savings will be consumed by fees? Vanguard founder John Bogle argues that fees have an enormous effect on 401(k) accounts, and that even small differences in fees can lead to drastically different retirement income.
One by one and year by year, the excess costs you pay for management, commissions, taxes and turnover can easily reduce your return by two percentage points...after a lifetime of modest investments, a return of 8% can leave you $2,755,274 to spend in retirement; but at 6%, those same investments can leave you with only $1,209,551.
Retirees also have to consider what returns are possible on their account, their current contribution level, the amount their employer matches, how long they plan to work, etc. Needless to say, the calculation gets confusing, especially since all of these different decisions affect each other in often unexpected ways.

To help illustrate the effect of each of these decisions, we have created an Excel spreadsheet that calculates monthly income (before taxes) at retirement given a variety of inputs such as current salary, contribution levels, account fees, etc. We also calculate the amount of fees paid both before and during retirement, and include the entire contribution and payout schedules over time.

Let's walk through the spreadsheet with a few examples.  We'll assume that each example has a pre-retirement 401(k) allocation that returns 6% and a post-retirement allocation that returns 3.5%, each with a fee of 1.5% annually.

Suppose you're a 25 year old who plans to retire at age 65 (in 40 years).  You contribute 6% of your $40,000 salary, your employer matches the first three percent and your salary grows at about 3% per year.  Assuming you've saved about $5,000, at retirement you'll have about $665,975 paying approximately $124,739 in fees up to retirement.  Let's say this retiree expects to live to age 80 and so needs 15 years of retirement income.  The retiree will have about $4,287 of pre-tax income each month; however the purchasing power of the monthly income will likely be greatly diminished by inflation.1

Suppose you're a 55 year old who plans to work through 70 (in 15 years).  You contribute 10% of your $60,000 salary, your employer matches the first five percent and your salary grows at about 4% per year.  Assuming you've saved about $150,000,  At retirement you'll have about $542,632 paying approximately $67,499 in fees up to retirement.  Assuming this retiree expects to live to age 80 and so needs 10 years of retirement income.  The retiree will have about $4,995 of pre-tax income each month.

Please feel free to download the spreadsheet and to try a variety of different parameters. You can change the cells with orange backgrounds to see the effects of each assumption. We think you'll agree -- when saving for retirement, there is a lot to consider!

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Assuming a 7% price inflation rate (conservative compared to the last 10 years), a tank of gas that costs $50 today will cost this retiree approximately $750 at retirement. Taking a 3% inflation rate for other purchases, a $100 grocery bill will come to about $326 at retirement.

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