8/20/2012 2:45 PM ET|
Determine your goals and their costs
PORTFOLIO 102: Complex isn't necessarily better. Once you know what your goals are, you may discover that a relatively uncomplicated route will take you to your destination.
We'd never show up at a party without knowing beforehand what type of party it was. Is it a formal dinner party for a dozen close friends or a frat-house kegger?
Yet we regularly invest -- squirreling away as much as we can -- without knowing whether we're saving enough for our goals. That's because most of us have no idea what our goals will cost.
For example, some financial-planning experts say we'll need 80% of our preretirement income to live comfortably once we stop working. In reality, thrifty retirees make do on less. Others, meanwhile, spend their retirements traveling, or taking up expensive hobbies. (Golf, anyone?) They spend more in retirement than they did while working.
This course aims to give you some idea what your goals may cost.
Annual cost of retirement
Sometimes the goal's annual cost is easy to estimate. Think of your yearly mortgage tab. Annual college costs aren't that tough to tabulate, either: Add together what the average college student pays for the cost of classes, books and room and board each year, multiply by four (or however many years you think the child will be in school) and you're at least in the ballpark.
Projecting your living expenses in retirement is another matter entirely -- especially if your retirement is decades away. It involves some dreaming, that's for sure. Ask yourself what type of lifestyle you want. Do you want to spend your retirement building birdhouses in your garage, or do you want to move to South Carolina and play golf every day? The first lifestyle will certainly cost less than the second.
To get a grip on what you might spend, analyze what you now spend each year and try to project what those costs will be in retirement. This isn't an exact science. Remember that you're just trying to get your arms around the issue.
Some expenses that will likely change in retirement include:
Housing costs. Most of us assume our mortgage will be paid off by the time we retire. That may be true. But what if we take out a line of credit on our home to install a new deck and swimming pool? Or what if we buy a second home in wooded Wisconsin or sunny Arizona? Housing costs don't always decline in retirement. Conversely, maybe we'll sell our homes and move into condominiums that not only cost less, but also require less upkeep.
Health-care bills. For most Medicare-qualifying retirees, health-care insurance isn't exorbitant. A good supplemental insurance plan (to cover what Medicare doesn't) may cost less than $200 per month. But not all plans cover prescriptions. Further, if you retire early and can't continue to participate in your former company's group insurance plan until Medicare kicks in at age 65, watch out. Long-term-care issues, such as living in a nursing home or hiring in-home care, should be accounted for, too.
Recreation. For many of us, retirement is about enjoying the things we denied ourselves while we were raising children or working. And those things -- whether traveling across the country in an RV or taking up tennis -- cost money. We'll likely eat out more, travel more and see more movies, plays and sporting events once we've left the working world. Those tickets aren't free.
Children. By the time most of us retire, our children will be on their own. We hope. But maybe you'll want to help your son with the down payment on a new home. Or maybe your thirtysomething daughter has returned home, forcing you to put off dreams of condo life for a few years. Once a parent, always a parent -- so budget like one.
Other items to include in a retirement expense form: transportation costs, which include cars, gas and insurance; taxes, which, thankfully, should decline for many of us; and those monthly bills for cable television, Internet access or cell phones. It adds up.
Number of years in retirement
Next, project how long you'll need to be paying for your goal.
Say that your goal isn't retirement, but sending your child through college. Will that expense stretch out over four years? Or is postgraduate study in the little one's future, too? Or maybe your goal is saving for a home and paying off a mortgage. The easy part is figuring out what you'd like to put down. But do you plan to use your investments to help pay your mortgage? If so, the goal for this pool of money may extend over 20 or 30 years, depending on the terms of your mortgage.
Back to the mother of all financial goals, retirement. Here, you need to consider just when you want to bid the working world farewell. Have you dreamed of an early retirement, or are you someone who can't imagine not working at least part time?
Then, unpleasant as it is, you'll need to project when you'll bid the world adieu. When it comes to life expectancy, think long. While most of us won't become centenarians, it's better to err on the side of longevity. Otherwise, you may run out of money.
When it comes to money, inflation is your worst enemy. $120,000 a decade from now will not have the same purchasing power as $120,000 today.
It's essential to make some assumptions about future inflation rates when estimating how much your goals will cost. When it comes to retirement planning, many advisers use a 2%, 3% or 4% inflation rate.
(College costs, however, have been growing well ahead of inflation. Some advisers recommend using higher rates when calculating future college costs.)
Congratulations, you now have some idea how much money you'll need to fund your goals. In the next few courses, you'll discover how to invest to meet those goals.
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