Projecting Your Retirement Income
The Financialist • Issue 83 • June 2004
BY CORY HILL
“I need a million dollars to retire!” This is a statement we advisors hear quite often.
Where does this number come from?
Sometimes, we encounter a client who has taken the time to carefully calculate what he or she will need during retirement. More often than not, however, there is no rational basis for the amount clients feel they need for a comfortable retirement. Most of the time, these are numbers bantered about in the media.
As financial advisors, part of our job is to de-mystify the retirement planning process by trying to determine how much our clients will need so that they can have a worry-free retirement. By carefully defining a client’s personal retirement income goals, we are able to illustrate exactly how much the client needs.
How do we do this? By using financial projections. A financial projection is a complex set of calculations used to simulate the growth of an investment portfolio over a number of years. We also use projections to estimate the income that can be generated by a given portfolio during retirement.
There are many variables and assumptions that go into a financial projection, such as rates of return, portfolio contribution amounts, inflation, tax rates, income needs at retirement, life expectancy, as well as sources of other income (pensions, etc.).
We use projection software that will factor in all of the above variables (and many more) to provide a complete picture as to how feasible your retirement income plan actually is.
Understand, however, that financial projections can be quite different than a client’s reality at retirement. The further one is from retirement, the more sensitive one must be to the various assumptions used in financial projections. A slight variation in assumptions can have a dramatic impact on one’s retirement picture.
Case Studies
To illustrate this, here are three case studies using a typical financial projection. This is meant to be a quick illustration and is by no means a complete or accurate financial projection.
George and Susan* are 15 years from retirement. Their goal is to retire with an after-tax income of $60,000 per year, indexed to inflation, which is assumed to be 2.5%. Assuming that their only source of income is from their investment portfolio, (which has a current value of $300,000) and that their expected annual rate of return will be 7%, George and Susan will need approximately $1,500,000 to generate their retirement income goal.
By contrast, Jerry and Elaine* are also 15 years from retirement, but their inflation assumption is only 1.5%. Keeping all other variables the same, they will need approximately $1,000,000 of retirement savings to realize the same income goal. It is amazing how different their required retirement savings needs are with just a 1% change in inflation assumptions.
Here’s another example. Two older couples, Frank and Estelle*, and Morty and Helen*; each have $1,000,000 of investment assets, which will be their only source of retirement income. Both couples are ready to retire. Each couple needs to know how much income their investments will generate throughout their retirement. Both couples expect a gross rate of return of 5%. Frank and Estelle assume inflation will increase at a rate of 2.5% per year throughout retirement. Morty and Helen, on the other hand, assume inflation will be 1.5% per year.
Based on these assumptions, Frank and Estelle can generate $45,000 of after-tax income throughout retirement, indexed to inflation at a rate of 2.5%.
Morty and Helen can generate $50,000 of after-tax income throughout retirement, indexed to inflation at a rate of 1.5%. Once again, we see what a difference a small change in the inflation assumption can make to one’s retirement income projections.
To help minimize the impact of inaccurate assumptions, your dvisor will usually focus on the real rate of return. The real rate of return is the difference between the gross rate of return and the rate of inflation. For example; if we are in a period of low inflation (as we are now), your advisor will reduce the expected rate of return for an investment portfolio so that the “spread” between the gross return and the real return is consistent with historical averages.
Conversely, if gross returns are abnormally high, your advisor will increase the inflation assumptions in financial projections so that the real return is in line with historical averages.
This is just one example of how we use financial projections to help you plan for a worry-free retirement. These examples are not meant to illustrate the full extent of how market events or changes in one’s retirement goals can affect your portfolio. Projections must be updated every few years to remain relevant to your situation.
If you would like more information about financial projections and how they work in planning your retirement, please speak to your Rogers Group Financial advisor.
* Not their real names