Basic Retirement Planning Questions
How much income will you need in retirement?
This is one of those good news, bad news subjects. The good news is that many of the expenses you had during your working years have disappeared. The bad news is that a few new ones (e.g., higher health care costs, increased travel and leisure expenses) may have taken their place. As a general rule, people tend to underestimate their post-retirement income needs. While every individual situation is different, assuming that you'll need eighty percent of your pre-retirement income is a good starting point. Let's say this amounts to $80,000.
The next step is to determine how much of your target income will have to be provided by your accumulated savings. In many cases, income from part-time work, your national social security system, and from defined benefit pension plans in which you have participated while working will provide a significant share of your target income. The key trade-off here (besides work versus leisure) is between employment income and pension income. Make sure to check whether your state and private pension plans place any limits on the amount of employment income you can receive without having your pension income reduced. Let's say these sources amount to $30,000. That leaves $50,000 in annual income (i.e., $80,000 less $30,000) that our investor's portfolio of financial assets must provide after he or she retires.
Another important point to keep in mind when making these calculations is what happens after a spouse dies. That usually, but not always affects the income received from these sources. For example, if a defined benefit pension plan provides a lifetime annuity only to one spouse, then his or her death may result in a substantial drop in income for the remaining spouse. On the other hand, if a couple decides instead to take a joint annuity, the annual payments received will be smaller, but will not terminate until the second spouse dies.
What are your savings goals?
After retirement, people save for two main reasons. The first is to protect their desired standard of living against unforeseen reductions in their income or increases in their expenses. For example, the first might be caused by cuts in your pension income. It is no secret that national pension plans in some countries are coming under pressure as the number of workers declines relative to the number of retirees. While both tax cuts and increases in the minimum retirement age are potential solutions to these problems, so too are cuts in the benefits paid to retirees. On the other hand, the main risk to a private pension comes when the company sponsoring it goes into bankruptcy, or out of business altogether. Under these circumstances, retiree benefits are often a prime candidate for cost cutting.
A closely related precautionary savings motive would be to provide income for a remaining spouse if the death of the first spouse would significantly reduce pension income.
Protecting themselves against increases in expenses is another reason retirees have precautionary savings. While the most common example of this is the cost of long term care later in life (either at home or in a nursing facility), unexpected house or car repairs also fall into this category.
The second major reason retirees save money is to provide for bequests to others after they die. As a practical matter, there are really two kinds of bequests: those you plan for, and those that result from you dying earlier than expected. So having a good estimate of your remaining life expectancy is very important for post-retirement investment management. One way to think about a bequest is in terms of a multiple of your annual portfolio income. Let's say, for example, that our investor wants to leave a bequest equal to ten times his or her annual portfolio income, or $500,000.
How long do you expect to live?
First, the good news. Studies have shown that retirees and near retirees are actually quite good at predicting their own expected remaining years of life (see, for example, "Perception of Mortality Risk: Implications for Annuities" by Drinkwater and Sondergeld). Further evidence of this is provided by the life insurance industry, which has found that people purchasing annuities (who derive maximum benefit only if they live for a long time) actually live longer than what standard mortality tables would predict.
The bad news, however, is that the chance you will outlive your savings, and suffer a sharp drop in your standard of living (known as "longevity" or "mortality" risk) usually gets less attention from retirees than concerns about their health and their investment returns.
One way to assess this risk is to look at standard remaining years of life tables, like the following one that comes from the US Social Security Administration, which shows estimated remaining years of life at different ages. Unfortunately, tables like this only show the "most likely" remaining life expectancy; in practice, there many outcomes on either side of this estimate (though there are some life expectancy calculators available that claim to provide more accurate estimates after you enter health and lifestyle data).
Given this, there is no way to escape the need to make a trade-off when dealing with what is technically called"longevity risk (or, more practically, "outliving your savings"). There are four ways to manage this risk, as we will discuss in the next section, "should you annuitize your savings?"