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Hong KongRetirement needs analysis, and the assumptions that decide it
Estimate the income needed, subtract guaranteed sources, capitalize the shortfall over the retirement period using an inflation-adjusted return, and compare with projected assets. The assumptions matter more than the arithmetic.
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
- Estimate the income needed in retirement, in today's dollars.
- Subtract guaranteed income - Social Security, any pension, annuity income.
- Inflate the shortfall to the retirement date.
- Capitalize it over the retirement period, using an inflation-adjusted return.
- Compare the capital needed with the projected value of current savings plus future contributions.
- 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.
The assumptions
| Assumption | Why it matters |
|---|---|
| Retirement age | Changes both the accumulation period and the withdrawal period |
| Life expectancy | Plan to at least 90, longer with family history or good health |
| Replacement ratio | Often 70 to 80 per cent of pre-retirement income, and it varies enormously |
| Inflation | Compounds over thirty years and drives everything |
| Return | Before and after retirement are usually different |
| Healthcare costs | Rise faster than general inflation |
| Social Security | Claiming age changes the benefit substantially |
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.
Working in today's dollars throughout, with an inflation-adjusted return, is cleaner than inflating every cash flow. Mixing the two - nominal returns with real cash flows - produces an answer that is confidently wrong and looks reasonable.
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.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
What is a retirement replacement ratio?
The share of pre-retirement income needed in retirement, conventionally 70 to 80 per cent. It falls as payroll taxes and saving stop, and rises with healthcare or travel plans.
What life expectancy should you plan to?
At least 90, and longer with good health or family history. Average life expectancy is the wrong assumption because half of clients live beyond it.
Should you use nominal or real returns?
Work in today's dollars with an inflation-adjusted return. Mixing nominal returns with real cash flows produces an answer that is wrong and looks reasonable.
Which assumption matters most?
Retirement age, because it changes both the accumulation and withdrawal periods. Inflation is close behind because it compounds over three decades.
How should the result be presented?
With sensitivity rather than as a single number - the effect of retiring two years later, spending ten per cent less, or earning one per cent less. Those show which lever the client controls.