The question many of your clients, especially the Baby Boomers, want to know is: How much money do I need to adequately fund my retirement? The answer, however, depends on several important variables and assumptions.
First, the variables include your client’s:
|• Current preretirement income||$_______|
|• Percentage of current income desired at retirement||_______%|
|• Amount of projected Social Security retirement benefits||$_______|
|• Age at retirement||_________|
|• Other income sources available at retirement (savings, etc.)||$_______|
|• Number of years retirement is expected to last||_________|
Assumptions must be made with regard to:
|• The average annual inflation rate before retirement||_______%|
|• The average annual inflation rate after retirement||_______%|
|• The average interest rate on investments after retirement||_______%|
Once you get this information, you can calculate the amount of capital needed to fund retirement. The following example explains the procedure.
Let’s say you have a client who is age 45 with the following set of facts:
|• Current preretirement income||$65,000|
|• Percentage of current income desired at retirement||80%|
|• Amount of projected Social Security retirement benefits||$21,600|
|• Age at retirement||66|
|• Other income sources available at retirement (savings, etc.)||$0|
|• Number of years retirement is expected to last||25|
|• The average annual inflation rate before and after retirement||3.5%|
|• The average interest rate on investments after retirement||8%|
Before you can begin calculations, you must make a realistic assumption regarding the inflation rates before and after retirement. The average increase in the Consumer Price Index (CPI) for the past 20 years (1985-2004) was about 3.1 percent. It is important not to assume an inflation rate that is too low because this will lead to an underestimation of the income and capital your client needs to retire comfortably. So, to be safe, we assume our client agrees that a 3.5 percent inflation rate is realistic both before and after retirement.
While conferring with the client, if he decides that 80 percent of current income ($65,000) is desired during retirement, that leaves $52,000 as the gross retirement income goal. Next, Social Security retirement benefits available for a 45-year-old earning $65,000 are approximately $1,800 per month, which is $21,600 per year. Since Social Security benefits are currently indexed to the CPI, they will increase along with the total amount of income needed, so it is safe to subtract $21,600 from $52,000 to arrive at an adjusted first-year retirement income goal of $30,400 needed in today’s dollars. However, retirement is 21 years in the future.
Therefore, this amount must be increased by the 3.5 percent inflation assumption for the next 21 years. So, a present value of $30,400 growing at 3.5 percent for 21 years requires a future income of $62,600 (rounded down to the nearest hundred) that is needed beginning at age 66.
It is prudent to factor a long life expectancy into the calculations, or to use a capital-retention assumption that does not liquidate capital.
But income need is not static, so it too must be indexed with inflation during retirement. In doing so, you need to make an assumption as to how long retirement will last. This involves estimating how long the client expects to live, which can be tricky. Sufficient capital will be needed to provide income that increases with inflation, but using the capital liquidation funding approach, the capital will be totally liquidated after an assumed time period that the client expects to live, such as 25 years. If the client dies sooner than age 91, any remaining lump-sum capital will pass to heirs. If the client lives longer, retirement funds exclusive of Social Security or pension payments received will be exhausted. Therefore, it is prudent to factor a long life expectancy into the calculations, or to use a capital-retention assumption that does not liquidate capital but instead retains it intact indefinitely. We will consider that as an alternative later.
The capital needed
So, with no other sources of retirement income, how much capital is needed to fund $62,600 of retirement income for 25 years that increases at an inflation rate of 3.5 percent? If an 8 percent investment interest rate is assumed, it has to be adjusted for inflation so that the purchasing power of $62,600 remains constant throughout retirement. The formula for determining an inflation-adjusted interest rate is:
[(1 + investment interest rate) ÷ (1 + inflation rate)] - 1 x 100
So in this case:
[(1 + .08) ÷ (1 + .035)] -1 x 100 = 4.35%
Thus, we need to calculate the present value needed to generate $62,600 per year for 25 years at 4.35 percent interest. Using a financial calculator, we find the lump sum capital needed is $984,000 (rounded up to the nearest thousand). However, this assumes that at age 91 the client’s money is exhausted. How much would it take to preserve the retiree’s capital until death, and maintain the constant purchasing power of $62,600 no matter how long your client lives?
The formula for determining this factor is:
(1 + investment interest rate) ÷ (investment interest rate – inflation rate)
So in this case:
(1 + .08) ÷ (.08 - .035) =
1.08 ÷ .045 = 24
If we then multiply 24 x $62,600, we see that it will take $1,502,400 to fund this client’s retirement on an inflation-adjusted basis without ever running out of money.
After your client gets over the shock of the price tag for adequate retirement funding using either method, the best service you can provide is to show them how they can meet their desired income goal if they start saving now.
Richard Dulisse, CFP, is an LUTC author and editor with The American College. Contact him at Richard.Deluisse@TheAmericanCollege.edu.