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August 29, 2006

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Are you talking about your savings or is this for you and your wife?

This is for both of us.

I am frequently confused by these retirement calculators because I don't know if I'm meant to enter my desired retirement income in todays dollars or inflation-adjusted future dollars.

For example, say I'm planning to retire in 30 years and I expect to need $70,000/year in today's dollars. If I expect inflation to be 2.5%, then I'll need almost $140,000 in 2036 dollars to have the same buying power that $70,000 give me today. So in this case do I enter $70,000 or $140,000 in the "Desired Income" field?

Obviously, it makes a HUGE difference in the results, and it annoys me that it is not explained better on these sites.

Keith --

That's why I did my own methods as well -- so I knew what number I was getting.

I've hear the "4% method" quoted by numerous sources, but I've always had two questions/reservations about this method:

1. Does it take into account inflation over the course of your retirement?

2. I've seen this method applied to retirement at various ages (both earlier and later than 65 years). Wouldn't the exact percent depend significantly on expected length of retirement?

1. Yes
2. No, not really, for a typical US age-based risk behavior

Consider 2 extreme cases:
A) age 40, life expectation 80 or more, you live longterm on only what you make good in real value year after year after tax and inflation, therefore all assets in stocks:
R=8.5 % expected annual return, T=25 % tax, I=2.5 % inflation, Retirement Yield Y = R * (1-T) - I = 3.9%
As long as your consumption stays under that, your real
value increases year after year
B) age 67, life expectation smaller than 92 (=67+25) or so, most of your assets in fixed interest with todays 4.5 % (= +1.2% real after tax and inflation) As long as annual return - taxes - inflation is better than 0,
your 1 / 4 % = 25 years expenditure can be consumed

In reality most the times your are somewhat inbetween those 2 extreme cases, both for age and asset allocation.

Of course, if you invest age 40 in government bonds with 4 %, have a tax rate of 30 % and inflation of 3 %, you will run out of money quickly

The main uncertainties in this game are predicting tax rates and inflation 20 or more years into the future

One last thing to consider is, to not take stock values at the peak of the bubbles, like 2000, but when they are in line with long term yield expectations, like 12/31/2005

Hope that helps you

Example and Question:

Let's say I want to retire when I am 60 or 30 years from now and I expect to live to 90.

** Need $50,000 a year in today's dollars to retire.
** In 30 years at 3.5%, that number balloons to $140,340 per year.
** Divided by 4%, $140,340 means I need $3.51 million at retirement

Okay, how exactly do I figure out when I will run out or if I will have enough then when I am 90?

Year 31 - 3.51mil - 140k = 3.37 mil
Year 32 - 3.37mil (1.05) - 140k (1.035) = 3.39 mil
Year 33 - what formula?

What about taxes?

Beef --

Check out this post for some help:

http://www.freemoneyfinance.com/2007/08/some-good-finan.html

In writing my book, "Who Said You Need Millions? Retirement Strategies for the Rest of Us," I did a lot of research about retirees and what they spend in retirement. Here is an excerpt from the book which discusses what working people actually spend, with the conclusion being that you may need a lot less in retirement than you think:

"Let’s look at some numbers about spending and expenses for people who are working. A working married couple, Sal and Sally Salmon, have a household income of $50,000 per year. If you run their income through a tax preparation program and assume that the Salmons don’t itemize their deductions, you’ll find that they owe around $7,825 in taxes, $3,825 of which is Social Security and Medicare payments (taxes for unmarried partners may be less). So in reality Sal and Sally are living on only 84 percent of their income after federal taxes, or $42,175.

If the Salmons live in a state with a state income tax, their $42,175 net take-home pay would be reduced further. The actual amount would depend on which state they lived in. Let’s say that their state income tax is $1,500. Now their net take-home pay is down to $40,675.

Next, consider the amount the Salmons are saving for retirement. The closer they are to retirement, the more they’re probably saving. But let’s assume they’re saving 15 percent of their income. That’s another $7,500. So now the Salmons’ net take-home pay is down to $33,175, or 66 percent of their earnings.

Next, consider all the expenses that they won’t have when they retire: dry cleaning, apparel or uniforms for work, barbers and hair stylists (don’t retirees always look a little disheveled?), cell phones (how many do they need now that they’re not working?), health clubs (they’ll try walking), four dollar cups of coffee, and eating out (retirees eat at home more than working people do). They’ll also spend less for transportation because they don’t have to drive to and from work every day. They may be able to reduce their expenses further if they consider owning fewer vehicles. On average, working people own more vehicles than retired people. Let’s conservatively estimate that all this costs the Salmons $3,000, so now their take-home pay is down to $30,175, or about $15,000 per person. That’s about double the $7,500 minimum consumption needs estimated by researchers, but the Salmons haven’t even tried to make any moneysaving lifestyle changes.

Consider also that once the Salmons retire, while they’ll still have to pay some federal and state taxes, those taxes should be significantly less than they paid when working because they’ll have less income and because some of their retirement income, such as withdrawals of retirement funds on which taxes have already been paid and a portion of their Social Security income, won’t be subject to some taxes.

Also, when the Salmons are retired, they’ll have considerably more leisure time. They’re apt to do a bit of traveling, but they can also use their leisure time to purchase goods and services more efficiently or to substitute home-produced goods and services for the ones they used to buy. For example, if they play golf, they’ll probably play during weekdays, when the courses are less crowded (because all the wage slaves are at work) and less expensive. Further, they’ll have time to do much of what they used to pay others to do because they were too busy working, such as lawn care, home maintenance, and car maintenance. And if they’re not working, they’re not in a rush to get all their chores done. They have more time to shop around and get a good deal on new (or used) items. The pace of life isn’t as frenetic as it was when the Salmons were employed. Life slows down and with it their expenses.

In addition, if they’ve paid off their mortgage, their housing costs should be lower. Finally, at some point their property taxes may be lowered, or increases abated, for many jurisdictions have property tax freezes for older residents.

Two major categories of expenses unfortunately won’t decrease in retirement. In fact, they’ll probably increase. One category is within the Salmons’ control; the other isn’t. The expenses within their control are leisure costs like travel and hobbies or whatever the Salmons will do with (and spend during) all their retirement leisure time. These expenses are discretionary, so Sal and Sally can control them as income dictates.

The category of expenses that isn’t within the Salmons’ control is health care costs. According to data from the Bureau of Labor Statistics, after retirement, health care costs will constitute a much larger percentage of retirees’ total expenses than they did when the retirees were working. Unlike many employed people, the Salmons may have to pay for their own health insurance (which isn’t cheap) until they reach age 65 and Medicare is available to them. Even after they’re eligible for Medicare, they may also want to have a supplemental health insurance policy that will pay for some of the costs that Medicare doesn’t cover."

So, as you can see despite the fact that some expenses, like health care costs, may go up after retirement, studies and statistics clearly demonstrate that the Salmons’ expenditures after retirement will be much less than they were when the Salmons were working, perhaps more than 50% less. This is true even though I haven't included the considerable expenses that working people spend on their children (sneakers, clothing, ipods, cellphones, cars, etc.). The money that working people spend on themselves is actually fairly small. So many people actually over budget what they'll be spending in retirement.

Jonathan D. Edelfelt

"If you withdraw 4% of your personal savings during your first year in retirement and adjust subsequent withdrawals to compensate for inflation, you're virtually assured of never outliving your money over a 30-year retirement."

That assumption doesn't work quite as well in an ongoing bear market. Retirees who continue through the second half of this bear market (another 7-11 years) and withdraw 4% annually, are in danger of running out of money later on.

The only thing that worked and will work is a strategy centered investment approach that blends at least three strategies that each have an offensive and defensive component.

Excellent discussion otherwise.

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