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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 |
