Understanding the Math of Retirement Planning

Finding your “turnaround point” and other key measures

The English language provides us a vocabulary of a quarter million words, give or take. But we really only have one word for “retirement.”

It’s not nearly enough. The days of the stereotypical rocking chair retirement, if they ever existed, are long gone. Retirements now come in every imaginable shade of gray, red, yellow and green.

Because retirement years can be spent in so many different ways, making concrete financial plans is complicated, demanding a careful look at many choices and variables. How much money will I need? When can I afford to retire? How should I invest my savings to generate the cash I will need after the last paycheck clears?

Inevitably, retirement planning involves a lot of questions, and a fair amount of math. Breaking down the issues and understanding how the math works are important first steps in creating rationale, achievable financial strategies.

Money in; money out

Let’s break the big picture into a few more manageable pieces. Think of the financial equations of retirement as a big bucket. Into the top of the bucket we pour money throughout our working years. Over time, the level of the bucket rises, both by adding money each year, and by expansion through investment returns. Upon retirement, the flow of money into the top of the bucket slows. At the same time, money starts dripping out of a hole in the bottom of the bucket to finance the many expenses of retirement – from food and clothing to healthcare and recreation. The goal, of course, is to achieve one’s desired retirement lifestyle without the bucket ever running dry.

Another way to look at these flows of money in and out of retirement savings is what we call the “turnaround point.” At some point in one’s career it should be possible to step on the brake on the way to work, turn around and go home — with the pleasing knowledge that without working another minute, funds available for retirement exceed the cash flows necessary to retire in comfort.

How much cash flow will I need at retirement?

Before we can judge how much must go into the top of the bucket, let’s consider how much we will draw out of the hole in the bottom. A good starting point is a simple analysis of current expenses. From current expenses – housing, transportation, utilities, education, healthcare, travel, charitable giving and others – one can begin to estimate retirement cash flow needs.

Each cash flow item should be considered separately. Which current expenses are discretionary and which are not? Which costs, such as college tuition or mortgage payments, will eventually end? Which, like long term care, may continue and grow over time?

The most common mistake in this area is to underestimate the cost of a satisfying retirement lifestyle. The Employee Benefit Research Institute’s 2008 Retirement Confidence Survey found that while almost 60% of those still working said they expected to spend less in the first five years of retirement, more than half of retirees said they had actually spent the same or more.¹ The impact of taxes is often underestimated as well. If specific reductions in spending cannot be identified with a high level of confidence, planning for retirement cash flows at 100 percent of pre-retirement levels is a reasonable default.

A couple spending $100,000 in the years leading up to retirement expects to need that same $100,000 each year to support a healthy and happy retirement. This figure must be adjusted for one very important variable – inflation. Even small annual inflation rates result in huge changes in what a dollar will buy over a 20-40 year retirement. For instance, a three percent annual inflation rate means that a $100,000 basket of goods and services in the first year of retirement would cost $243,000 in the thirtieth year of retirement. Cash flow planning must account for this dramatic decline in purchasing power over time.

How long will retirement last?

Understanding expenses lets us predict the rate at which money flows out of the bucket. But how long must it flow? We can generally control when retirement begins, but when it ends is another matter.

In general, each generation lives longer than the one that precedes it. Life expectancy at birth in 1950 was 66 for males and 71 for females. By 2005, these figures had increased to 75.2 and 80.4, respectively. And life expectancy changes with age as well. For example, additional life expectancy for a person who reaches age 65 is 17.2 years for males and 20.0 years for females. This means that at birth, males have a life expectancy of 75.2. However, if they reach age 65, life expectancy increases to 82.4, an increase of seven years.² For couples, of course, the relevant life expectancy is that of the “second-to-die,” which is greater than it is for either separately.

Of course, all of these figures are actuarial averages. How long each individual lives depends on medical history, risk factors, and imponderables such as accidents. And making financial plans based on the average is very dangerous — because 50% of a given population lives longer than the average.

A more prudent planning horizon is the life expectancy of the “top 20%” — the 20% of the population that lives the longest. Planning for this best-case outcome means only a one-in-five chance of outliving one’s assets. The table below, using data from a 2004 report from the Center for Disease Control, indicates the additional life expectancy for the top 20% after reaching various ages between 55 and 70.

The data shows, for example, that a 70 year-old female has a one-in-five chance of surviving 23 years or more. Of course, many people now live to 100 or more.

While many factors affect longevity, a prudent retirement plan would typically be based on optimistic life expectancy projections such as the top 20% data presented above.

How will I pay for retirement?

We have looked at some of the variables that determine the amount of money that will come out of the bucket to fund retirement. Now let’s consider what must go into the top to support those cash flows.

Retirement cash flow typically derives from a mix of sources, including pensions, inheritance and Social Security. A family business or real estate may contribute ongoing cash flows. The rest, often the majority, must come from investments, both in tax-favored 401k and IRA plans and in taxable accounts.

How much do I need to generate through investments?

Consider an individual with the following mix of annual retirement cash flow sources, with an expected retirement length of approximately 30 years:

If this retiree forecasts total cash flow needs of $100,000 per year, that leaves a $40,000 burden that must be supported by withdrawal of savings and investments. Using this $40,000 annual figure, we can estimate the size of the investment portfolio needed to support withdrawals of this size.

A four percent annual withdrawal rate is often used as a guideline for retirement – low enough to sustain payments over several decades without counting on heroically high returns from stocks and bonds. Assuming this four percent annual withdrawal, the investment account in this example should hold approximately $1,000,000 at the start of the retirement. While not guaranteed, there is a high probability that this sum, properly invested, would continue to provide $40,000 per year (adjusted for inflation) for 30 years.³

Turn around and relax

In this simplified example, the turnaround point – the moment when assets are sufficient to support the desired retirement without continuing to work – is the time at which investments equal $1,000,000 and the expected retirement length is no longer than 30 years.

Obviously, this turnaround point is based on a number of assumptions that should be carefully made and periodically reevaluated. For instance, if retirement is likely to continue for more than 30 years for one or both spouses, if spending accelerates, or if inflation rises for an extended period, a larger nest egg will be needed. If actual pension or Social Security benefits fall short of expectations, retirees must replace that income with additional savings or reduce spending. And if investments return less than historically-predicted returns, savings will last for fewer years. Making conservative assumptions reduces risk of shortfalls, of course.

What does this all mean for me?

For an individual or couple looking ahead 10, 20 or 30 years to retirement, the most important message is to not think of retirement planning as something that can be ignored or indefinitely delayed. Understanding the basic mechanics, framed here as the money-in and money-out bucket, illuminates the need to save and invest throughout one’s entire career and keep retirement expenses to reasonable levels.

We encourage individuals to consult a wealth management professional and start playing with the numbers early in their careers. Projecting cash flows needs in retirement and evaluating investment strategies of varying risk and return characteristics clarify the important variables that will ultimately dictate the standard of living that can be enjoyed during retirement.

The first step into this arena is the hardest, but the most important.

¹“Got Enough to Retire? Think Again,” Money Magazine, October 24, 2008.
²www.cdc.gov/nchs/fastats/lifexpec.htm
³ This is often structured as follows. The withdrawal amount in year one is four percent of the portfolio total. In the second year, the dollar amount of the first year withdrawal is increased to account for inflation. In this hypothetical example, the first year withdrawal of $40,000 might be increased to approximately $41,000 in year two, approximately $42,200 in year three, and so on.

By Mark L. Smith, CPA, PFS, Managing Member of Solutions for Wealth Management, LLC, an independent founding member of Bright Sky Group. © 2010 All rights reserved.

Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.

Bright Sky Group member firms are each registered investment advisers, which are independently owned and operated from each other. Bright Sky Group provides general financial information. The services, securities and financial instruments described by Bright Sky Group may not be available to or suitable for you, and not all strategies are appropriate at all times. The value and income of any of the securities or financial instruments mentioned herein can fall as well as rise, and an investor may get back less than he or she invested. Foreign-currency denominated securities and financial instruments are subject to fluctuations in exchange rates that could have a positive or adverse affect on the value, price or income of such securities and financial instruments. Independent advice should be sought for an investor’s specific needs.