It's a common set of questions: How much will I have in savings when I retire and am I using the right tools to get there?
Let's tackle the first one first.
There are four components to this kind of retirement savings projection:
1. Investment returns
While financial planners often use historical average returns for these assumptions, you may be wise to be more conservative. Assuming lower-than-average returns will help you prepare for sub-par market conditions, and is especially appropriate these days since bond yields are much lower than their historical norms.
Over the past 50 years, inflation has averaged 4.07 percent a year. That may not sound like much, but it is enough to cut the purchasing power of your money in half every seventeen years or so. When planning for future needs, you have to use inflation-adjusted targets rather than thinking in terms of today's dollars.
3. Savings rate
Based on your income and budget, figure out how much you can plan on saving each year. This is a key component to focus on, because unlike investment returns and inflation your savings rate is something you can control. Just don't make the mistake of assuming that you can catch up with higher savings rates in later years — challenge yourself to save aggressively from the start, because it often does not get any easier as you get older.
Forget about rules of thumb about replacing a certain percentage of your income. What you need to focus on is projecting your retirement spending so you have a feel for what expenses your savings will have to cover.
Between financial market returns and inflation, there is a strong element of unpredictability to retirement saving. Even so, making a reasonable estimate based on conservative assumptions gives you a starting point in terms of savings targets. As long as you are prepared to make regular course corrections to keep your savings rate on track, the picture should steadily become clearer as you approach retirement.
Related >> The Essential Guide to Retirement
Another central retirement question is whether target date funds are worth it. Here's more on that:
Target date funds are a convenient approach for retirement savers who do not want to make complex investment decisions. They provide an easy way of giving people an asset mix that is generally appropriate for their time horizons. In doing so, they should also provide adequate diversification because they not only invest across a range of different stocks, but they also invest in different asset classes.
With that said, it should be noted than an inherent limitation of target date funds is that they essentially assume that all people with the same time horizon have identical investment objectives, but this may not be the case.
Some people are just more comfortable with taking risk than others, and so may want a more aggressive asset mix. Your investment approach may also vary according to how much money you have accumulated so far. If you have already put together a substantial nest egg, you may want to dial down the risk a little so as not to jeopardize it. On the other hand, if you have gotten a late start on retirement saving, you might be inclined to take a more aggressive investment approach in an effort to catch up.
So, two people of the same age and with the same number of years until retirement might reasonably wish to take different investment approaches. Therefore, it might be helpful to view a target date fund as a starting point, from which you might do some fine tuning to make it fit the specifics of your situation.
One final note about target date funds – make sure they do not get too conservative when you reach retirement age. You may live twenty or thirty years in retirement, meaning that you are likely to continue to need some active investments. In other words, the target date should not be thought of as an end date for your investment program.