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Estimating Retirement Income Needs - The Discounted Approach
By JLP | August 19, 2008
Let’s say you want to retire at age 65 on January 1, 2009. Not including Social Security, you desire $50,000 in income the first year of your retirement and you would like that $50,000 to increase 3% each year as an inflation adjustment. You expect to live 25 years in retirement.
Question: Assuming the above information, how much income will you need during your 25-year retirement?
Answer: $1.8 million! I’ve laid it all out in the following graphic (you can click on the graphic to see a larger version):
You can also calculate this by using the Future Value (FV) function in Excel, entering the information like this:
Both ways arrived at the same answer: $1.8 million. Now, this doesn’t mean you must have $1.8 million in your retirement account on the day you retire. Why? Because your retirement account will grow during your retirement. To estimate how much you need in your retirement account on the day you retire, you have to discount each year’s income need at your expected growth rate. Got that? It’s easier than it sounds.
The formula for discounting a future cash flow looks like this:
So, if you look at the graphic from above, you’ll see that the income need for year 2 is $51,500. If you expect to get a 6% return on your retirement account during retirement, you can discount year two’s income need like this:
Then you simply perform this calculation for each year’s income need and sum the results. Here’s a table showing the discounted income needs at various rates of return:
As you can see, the higher the expected return, the less capital you need. Of course, the higher your expected return, the more risk (volatility) you agree to take on. It’s important to note that this is considerably less conservative than the capitalization approach that most financial planners use.
Under the capitalization approach, you decide how much income you want the first year, and divide that amount by your desired withdrawal rate. So, if you want $50,000 per year and you only want to withdraw 4% of your account’s value, you will need $1.25 million on the day you retire. You then hope that your account balance grows by at least as much as the inflation rate. This approach requires a lot more money but is also more conservative because it assumes that your goal is to never use your principal.
Interestingly enough, I went on Vanguard’s website and did a fixed annuity quote using the information from this post and got the following result:
I’m not recommending you hand over nearly $900,000 to Vanguard (AIG actually) because you would lose control of your money. But, I see nothing wrong with doing this with a portion of your money.
The main thing to keep in mind is that under this approach, once the money’s gone, it’s gone! Unless you have other money sitting around, if you live past 90, you’re in trouble (not counting Social Security).
UPDATE: As the first commenter mentioned, the ‘flaw’ with this post is that you have to be 65, ready to retire next year, and have $900,000 in the bank. Yes, I had to make some assumptions for this post. Naturally, the farther you are from retirement, the more difficult it is to estimate your income needs, but that wasn’t the point of this post.
Topics: Retirement Planning |
August 19th, 2008 at 12:04 pm
Only problem is that you need to be 65 retiring next year and already have all that money saved.
August 19th, 2008 at 12:12 pm
No, it’s not a problem. I just needed a basis for a starting point. Naturally, the farther you are from your goal, the more difficult it is to gauge how much you’re going to need.
August 19th, 2008 at 12:46 pm
“Let’s say you want to retire at age 65 on January 1, 2009. Not including Social Security, you desire $50,000 in income the first year of your retirement and you would like that $50,000 to increase 3% each year as an inflation adjustment. You expect to live 25 years in retirement.”
Sounds greedy. Who needs $50K a year in retirement?
August 19th, 2008 at 2:38 pm
I don’t think that the 50K per year sounds greedy but when you’re at your retirement age would you really need as much money? What kind of assumptions are being taken with that 50K - is the house paid off? Do you have any existing debts? If the answer is no to these then I can see needing more money but if they’re paid off and you’re just paying for your living expenses and travel then you might not need as much money.
August 19th, 2008 at 2:43 pm
Matt,
I just came up with $50,000 off the top of my head.
August 19th, 2008 at 5:01 pm
Are there any websites that allow you to input retirement values currently (what have been saved up to this point) and what the prospects for retirement are assumming current rates of savings?
I believe this would help people better guage what they will have available during retirement. Which may enable them to save more if their savings at retirement is not enough.
August 19th, 2008 at 5:53 pm
Irene, you might want to check out the calculators at http://www.moneychimp.com. Start with the compounded interest calculator: your current value is what you’ve saved for retirement; you then add the approximate amount you’ll save until retirement per year; then the number of years until you plan to retire; then (finally) a conservative interest rate to compound the above. That will give you the amount in non-inflation-adjusted dollars you’ll have to start retirement. The switch to the annuity calculator. Insert the amount you’ll have to start retirement, the number of years you expect to live, a projected interest rate to compound, and you’ll see the yearly payout.
It’s simplistic, and doesn’t adjust for inflation, but it’s free and easy to use. At least it’s easier than a manual calculator.
Yours,
Bozo
August 19th, 2008 at 6:58 pm
PS to JLP and Irena:
If you use the moneychimp annuity calculator, using $1,000,000 as the starting principal, a 2% real rate of growth (5% - 3% inflation), and 25 years payout, you get a smidge over $50,000/year. So all these calculators seem to work alike. It’s just if you use inflation-adjusted dollars (subtracting inflation from your anticipated return, as I did above), you get a better feel for what you’ll really need.
Of course, the irony in all these calculators is the assumptions they make. Will you really average 5%? Will inflation really be 3%? Would you have to live through the year 2200 to see those “averages”? That’s a whole ‘nuther issue, as they say.
August 19th, 2008 at 8:00 pm
ok gang my wife and i are real lucky to be retired at 53 - living on approx 60k easy. mortgage a grand a month, health insurance for the two of us high deductible $308 per month, swim/tennis club $130 per month. and we’re total jocks so we expect to do this a long time. when you get to be our age; you spend effectively zero on clothes, go out to eat very little - essentially remove frivolous expenditures from the picture. hard to realize in your 20’s and 30’s how much that saves…
August 19th, 2008 at 9:11 pm
I can’t pass up this golden opportunity to plug the software I’ve spent much of the last 3 years producing, LifeCALC. It makes this genre of analysis a breeze, not to mention the ability to simultaneously analyze/solve many goals/responsibilities. I couldn’t find a tool that would let me do this for my family responsibilities, and the rest is history …
August 23rd, 2008 at 8:27 pm
Thinking about retirement amounts is certainly a worthwhile activity. However, what I’ve always wanted is a calculator to show me how I’m doing compared to how I should be doing for someone my age.