If there is one question that has captured the wallets and imaginations of baby-boomers contemplating retirement, it must be: Do I have enough … or will I live longer than my money?
Although I have spent a large part of my professional career pondering a myriad of financial matters, I must say that this particular vexing question — with all the complications of health care, income taxes and financial markets — might be one of those riddles wrapped in enigmas, to which it is impossible to provide a fully satisfying answer.
Unfortunately, a growing number of the retirement planning “tools and philosophies’’ that are widely used to answer these questions often give misleading results. More problematically, they then generate a false sense of security that you indeed do have enough, when in fact you don’t.
Now normally such problems would be beyond the mandate of this particular column. But one of the by-products of this faulty logic is that lifetime income products and specifically life annuities often get the short end of the stick when viewed through these tainted lenses. This, I believe, must be corrected and is the impetus for this month’s column.
Let us start with some basic retirement arithmetic. Imagine you are exactly 65 years old and would like to retire today. Besides the entitled income from government and corporate pensions, assume that you need an additional cash-flow of $1,000 per month ($12K per year) for the rest of your life. I will assume that you are not fooled by, or suffer from, what economists call money illusion and that these monthly desires are expressed in real inflation-adjusted terms (i.e. today’s dollars.)
So, how much of a lump-sum nest egg do you need today to generate this specified stream of income for the rest of your life?
Fortunately, this much more limited question is easier to address. The route to an answer begins with a present value analysis that assumes an investment return and assumes an investment horizon. Once you make these two assumptions, any business calculator can provide you with an answer. I have taken the liberty of displaying some values in the table on the next page, under a variety of life horizons and investment returns.
In particular, you will see values assuming investment returns of 0%, 1.5%, 4.0% and 6.5%, and income plans that last to age 84, 90 and 97. I have selected these odd-looking numbers deliberately, for reasons that should soon be clear.
I have also — in the same table — displayed the actual cost of a $1,000 per month life annuity, purchased at the age of 65, which is approximately $230,000 in today’s financial environment. This particular number is harder to obtain — a business calculator isn’t enough — and you have to contact your favorite insurance company for that. I’ll say more about the implication of this number in a moment.
(Click here to jump back to Table on page 1)
Here is how to read and interpret the table. If you are retiring at the age of 65 and would like a $1,000 monthly income stream until life expectancy, which is age 84.2 — after which, I presume, you plan to shoot yourself — and this money is invested at a real rate of 1.5%, then you need a nest egg of a little over $200,000 at retirement. So says the math.
If you don’t trust these present value formulas then go ahead and build a spreadsheet to convince yourself that $200,000 invested at 1.5% / 12 = 0.125% per month (plus inflation) that experiences monthly withdrawals of $1,000 (plus inflation) will exhaust itself in exactly 19.2 years, which is the 50% mark on the longevity tables.
Now I deliberately selected 1.5% as the investment return in the above paragraph, since it is the best rate you can actually guarantee in today’s environment on an after-inflation basis. Note that in late July 2011, long-term inflation-linked (government) bonds are yielding 1.5%. We all might believe this is artificially low, but it is the best you can get if you want something that is guaranteed. The mighty bond market speaks.
Of course, if you worry about events that have probabilities smaller than 50% — like living beyond life expectancy — and you plan your retirement to the 75th percentile, which is age 90, then you need a retirement nest egg of approximately $251,000. This will generate the $1,000 monthly income for the extra six years. Stated differently, the present value of $1,000 per month until the age of 90 is $251,000 when discounted at 1.5%. And, if you worry about events with probabilities smaller than 25% and you plan to the 95th percentile of the mortality table, which is age 97, then you need a nest egg of $306,000 to generate the $1,000 of monthly income. Big numbers. Low rates.
This is a basic application of the time value of money, given today’s interest rates. Needless to say, most people look at the $305,000 price tag for a meager $1,000 of income and balk, or they get very depressed. Scale this up by a factor of 10, for those who want a monthly income of $10,000, and retirement will cost a cool $3 million if you want the money to last to the age of 97 — which is the 95th percentile of your lifespan.
So, time to take-up smoking, boozing and ditch the exercise bike?
Enter the retirement planning software used by confused — or unscrupulous — financial advisors and they seem to offer a better and more soothing answer. If you invest more aggressively then you don’t have to use the small, pathetic and depressing 1.5% real return column in the above table. If you purchase more equity-based mutual funds, or invest more heavily in stocks, then you are entitled to use the much higher 6.5% column — “Because in the long run, stocks have averaged 6.5% after inflation, even if you include the fees I will be charging.”
(Click here to jump back to Table on page 1)
So, if you are willing to take a bit more equity market risk, all you need is $131,600 at retirement if you plan to life expectancy. And, even if your retirement horizon is age 90, then all you need is $148,600 at retirement, per $1,000 of monthly income. As for age 97, don’t worry about it (they say). Most people don’t reach that age.
Either way, as you can see, these numbers — how much you need at retirement — are certainly much less than the ones under the 1.5% column. Fix your asset allocation. Repair your portfolio. Assume your problems away. So says the software.
And, if you only have $100,000 in your retirement account and you absolutely must have $1,000 per month until age 85, here is another way to make the numbers dance.