Personal Financial Planning: An "How-To" Guide (part 54)

Retirement Planning: Estimating Income Needs
by
Charles Lamson

The combined impact of when you start your program, how much you contribute each year, and the rate of return you earn on your investments is seen in Exhibit 1 (below). Note that it is really the combination of these three factors that determines the amount you will have at retirement. Thus, you can offset the effects of earning a lower rate of return on your money by increasing the amount you put in each year or by lengthening the period over which you build up your retirement account---meaning that you start your program earlier in life (or work longer and retire later in life). The table shows that there are several different ways of getting to roughly the same result; that is, knowing the kind of nest egg you would like to end up with, you can pick the combination of variables (period of accumulation, annual contribution, and rate of return) that you are most comfortable with.

Retirement planning would be much simpler if we lived in a static economy. Unfortunately (or perhaps fortunately), we do not, and as a result, both your personal budget and the general economy are subject to considerable change over time. All of which make accurate forecasting of retirement needs difficult at best. Even so, it is a necessary task, and one you can handle in one of two ways. One strategy is to plan for retirement over a series of short-run time frames. A good way to do this is to state your retirement income objectives as a percentage of your present earnings. For example, if you desire a retirement income equal to 80 percent of your final take-home pay, you can determine the amount necessary to fund this need. Then, every 3 to 5 years, you can revise and update your plan.

Alternately, you can follow a long-term approach in which you actually formulate the level of income you would like to receive in retirement, along with the amount of funds you must amass to achieve that desired standard of living. Rather than addressing the problem in a series of short-run plans, this approach goes 20 or 30 years into the future---to the time when you will retire---to determine how much saving and investing you must do today to achieve your long-run retirement goals. Of course, if conditions or expectations should happen to change dramatically in the future (as they very well could), it may be necessary to make corresponding alterations to your long-run retirement goals and strategies.


Determining Future Retirement Needs

To illustrate how future retirement needs and income requirements can be formulated, let's consider the case of Jack and Lois Spellman. In their mid-thirties, they have two children and an annual income of about $60,000 before taxes. Up to now, Jack and Lois have given only passing thought to their retirement. But even though it is still some 30 years away, they recognize it is now time to give some serious consideration to their situation to see if they will be able to pursue a retirement lifestyle that appeals to them. Worksheet 1 provides the basic steps to follow in determining retirement needs. This worksheet shows how the Spellmans have estimated their retirement income and determined the amount of investment assets they must accumulate to meet their retirement objectives.

Jack and Lois began their calculation by determining what their household expenditures will likely be in retirement. Their estimate is based on maintaining a "comfortable" standard of living---one that will not be extravagant yet will allow them to do the things they would like in retirement. A simple yet highly effective way to derive an estimate of expected household expenditures is to base it on the current level of such expenses. Assume that the Spellmans' annual household expenditures (excluding savings) currently run about $42,000 a year---this information can be readily obtained by referring to their most recent income and expenditures statement. Making some obvious adjustments for the different lifestyle they will have in retirement---their children will no longer be living at home, their home will be paid for, and so on---the Spellmans estimate that they will be able to achieve the standard of living they would like in retirement at an annual level of household expenses equal to about 70 percent of the current amount. Thus, in terms of today's dollars, their estimated household expenditures in retirement will be $42,000 x .70 = $29,400. (This process is summarized in steps A through D in Worksheet 1.)



Estimating Retirement Income

The next question is: Where will they get the money to meet their projected household expenses of $29,400 a year? They have addressed this problem by estimating what their income will be in retirement---again in terms of today's dollars. Their two basic sources of retirement income are Social Security and employer-sponsored pension plans. Based on today's retirement tables they estimate that they will receive about $13,000 a year from Social Security (you can receive an estimate directly from the Social Security Administration of what your future Social Security benefits are likely to be when you retire) and another $9,000 from their employer pension plans, for a total projected annual income of $22,000.                     When this is compared to their projected household expenditures, it is clear the Spellmans will be facing an annual shortfall of $7,400 (see steps E through I in Worksheet 1). This is the amount of retirement income they must come up with; otherwise, they will have to reduce the standard of living they hope to enjoy in retirement.

At this point we need to introduce the inflation factor to our projections in order to put the annual shortfall of $7,400 in terms of retirement dollars. Here we make the assumption that both income and expenditures will undergo approximately the same average rate of inflation, causing the shortfall to grow by that rate over time. In essence, 30 years from now, the annual shortfall is going to amount to a lot more than $7,400. How large it will grow to will, of course, be a function of what happens to inflation. Assume that the Spellmans think inflation, on average, over the next 30 years will amount to 5 percent---while that is a bit on the high side by today's standards, the Spellmans decide to use it anyway as they would rather overestimae the effects of inflation than underestimate them.


Funding the Shortfall

The final two steps in this estimation process are to determine (1) how big the retirement nest egg must be to cover the projected annual income shortfall, and (2) how much to save each year to accumulate the required amount by the time the Spellmans retire. To find out how much money they need to accumulate by retirement, they must estimate the rate of return they think they will be able to earn on their investments after they retire. This will tell them how big their nest egg will have to be by retirement in order to eliminate the expected annual shortfall of $32,000. Let's assume that this rate of return is estimated at 10 percent, in which case, the Spellmans must accumulate $320,000 by retirement. This figure is found by capitizing the estimated shortfall of $32,000 at a 10 percent rate of return: $32,000 / .10 = $320,000 (see steps M and N). Given a 10 percent rate of return, such a nest egg will yield $32,000 a year: $320,000 x .10 = $32,000. And so long as the capital ($320,000) remains untouched, it will generate the same amount of annual income for as long as the Spellmans live and can eventually become a part of their estate.

Now that the Spellmans know how big their nest egg has to be, the final question is: How are they going to accumulate such an amount by the time they retire? For most people that means setting up a systematic savings plan and putting away a certain amount each year. The appropriate interest factor is a function of the rate of return one can (or expects to) generate and the length of the investment period. In the Spellmans case, there are 30 years to go until retirement, meaning that the length of their investment period is 30 years. Because the Spellmans must accumulate $320,000 by the time they retire, the amount they will have to save each year (over the next 30 years) can be found by dividing the amount they need to accumulate by the appropriate interest factor; that is $320,000 / 113.3 = $2,824 (see steps O to Q in Worksheet 1).

The Spellmans now know what they must do to achieve the kind of retirement they want: Put away $2,824 a year and invest it at an average annual rate of 8 percent over the next 30 years. If they can do that, they will have their $320,000 retirement nest egg in 30 years. Of course, they could have been more aggressive in their investing and assumed an average annual rate of 10 percent, in which case, either they would end up with a bigger nest egg at retirement, or they could get away with saving less than $2,284 a year. Now, how they actually invest their money so as to actually achieve the desired 8 (or 10) percent rate of return will, of course, be a function of the investment vehicles and strategies they use. All the worksheet tells them is how much money they will need, not how they will get there; it is at this point that investment management enters the picture.

The procedure outlined here admittedly is a bit simplified and does take a few shortcuts, but considering the amount of uncertainty imbedded in the long-range projections being made, it does provide a viable estimate of retirement income and investment needs. The procedure certainly is far superior to the alternative of doing nothing. One important simplifying assumption in the procedure, though, is that it ignores the income that can be derived from the sale of a house. The sale of a house not only offers some special tax features but can generate a substantial amount of cash flow as well. Certainly, if inflation does occur in the future (and it will), it will very likely drive up home prices right along with the cost of everything else. A lot of people sell their homes around the time they retire and either move into smaller houses (often in Sun Belt retirement communities) or decide to rent in order to avoid all the problems of homeownership. Of course, the cash flow from the sale of a house can have a substantial effect on the size of the retirement nest egg. However, rather than trying to factor it into the forecast of retirement income and needs, we suggest that you recognize the existence of this cash flow source in your retirement planning, and consider it as a cushion against all the uncertainty inherent in retirement planning projections.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 598-603*

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