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Looking at Retirement Income Needs
By JLP | April 21, 2008
This is a follow up to my previous post, Common Questions: How Much Do I Need to Save for Retirement?.
One way to look at retirement needs is to estimate how much income you will need over the life of your retirement. Using the numbers from the previous post, we’ll assume that your inflation-adjusted first-year income need is $182,045. If we assume a 3% inflation rate, in year two of retirement, you will need $187,506. Over 25 years, this is what the income needs would look like:
Based on these numbers, we can see that the total income needs over a 25-year retirement are over $6.6 million. Fortunately, you don’t have to have all $6.6 million available to you the first day of retirement. Why? Because you will most likely be able to invest your money so that it will grow during retirement. That means that we need to adjust each year’s income needs to reflect the growth of the retirement account. In financial terms, we need to discount the future cash flows by our expected rate of return using this formula for each year’s income need and then add the results together to arrive at a present value for the income stream:
PV = FV ÷ (1 + ROR)N
where…
PV = Present Value
FV= Future Value
ROR = Expected or Required Rate of Return
N = Year of the Cash Flow
For example, we’ll discount Year 2’s income need using a 7% expected rate of return. Using the formula above, the equation looks like this:
PV = $187,506 ÷ (1 + .07)
PV = $187,506 ÷ 1.07
PV = $175,239
Year 3’s income need would be discounted like this:
PV = $193,131 ÷ (1 + .07)2
PV = $193,131 ÷ 1.072
PV = $193,131 ÷ 1.14
PV = $168,688
Repeating this for each year’s income needs, we get the following:
So, this tells us that if you retired at age 65 with a balance of $2,991,080, you could withdraw your first year income need of $182,045, and increase each year’s income need by 3% for 25 years IF your account value grows at 7% per year.
As we all know, this is just a hypothetical illustration. Some years your account will grow by more than 7% and some years it will grow by less than 7% or it could even lose value at which point you would have to assess your situation and decide what action you would want to take. The important thing is to not be too aggressive with your expected rate of return. You can also run the calculation using a lower expected ROR during retirement. I used 7% as I think it is a fairly conservative estimate.
Topics: Retirement Planning |
