Retirement Needs Analysis

A time value of money calculation wrapped around half a dozen assumptions, any of which can move the answer by more than the maths does.

The steps

1. Estimate the income needed in retirement, in today's dollars.
2. Subtract guaranteed income - Social Security, any pension, annuity income.
3. Inflate the shortfall to the retirement date.
4. Capitalize it over the retirement period, using an inflation-adjusted return.
5. Compare the capital needed with the projected value of current savings plus future contributions.
6. Solve for the additional saving required.

Step four is where the inflation-adjusted rate is used, and it is where candidates most often use the nominal rate by mistake.

Calculate the annual retirement income gap

First put the income goal and expected income sources in the same units, period, and dollar basis. Then subtract the income sources expected to meet the goal: annual income gap = annual retirement income target − Social Security − pension or annuity income − other reliable income. Use an estimate that reflects the client's expected claiming age and actual benefit record rather than assuming everyone receives the same Social Security amount.

For example, if a household's target is $80,000 a year in today's dollars, and its estimated Social Security and pension income total $48,000 on the same basis, the annual gap is $32,000. The portfolio may need to support that gap, subject to taxes, investment returns, spending changes, and the timing of withdrawals. The gap is a cash-flow need; it is not itself the lump sum of assets required at retirement.

• If the benefit estimate is in future inflated dollars while the spending target is in today's dollars, convert one side before subtracting.
• If income is monthly, convert it consistently before comparing it with an annual spending goal.
• Use a pension's expected survivor or joint-life form when projecting a couple's income after the first death.
• Separate reliable lifetime income from withdrawals that depend on portfolio performance.
• Consider taxes and healthcare costs in the spending target rather than silently assuming the gross income gap is the net amount available to spend.

The assumptions

The replacement ratio

Seventy to eighty per cent of pre-retirement income is the conventional starting point, and it is only a starting point. Only a start.

It falls because payroll taxes stop, retirement saving stops, commuting stops, and the mortgage may be repaid. It rises where healthcare, travel or supporting adult children is significant.

A client planning to travel extensively for a decade needs more than 100 per cent for that decade, and a schedule that assumes a flat number misses it.

Longevity

Average life expectancy is the wrong planning assumption, because half of clients live longer than it. Plan past it.

For a couple, joint-and-survivor longevity is longer still - the probability that at least one survives to a given age is higher than for either alone. Planning to the average is planning to run out half the time.

Presenting the sensitivity

A single number invites false confidence. Showing the effect of retiring two years later, spending ten per cent less, or earning one per cent less is more useful than a point estimate to the dollar. Show a range.

It is also better advice, because it identifies which lever the client actually controls - and the two largest are usually retirement date and spending.