Retirement Planning: Income, Annuities, and Investment Strategy

Defining Retirement and Estimating Future Expenses

Retirement means different things to different people. For some, retirement means being sufficiently financially independent to travel and relax around the clock. Others may view retirement as a "career change." How an individual views retirement will help determine how much he or she will need to retire. Will the lifestyle change dramatically in retirement, or will an individual continue doing the things they currently do, trading work for leisure and volunteering? Will they incur more expenses in retirement for leisure and travel, or will they prefer to spend more time with children, grandchildren, and family?

To get a better idea of what expenses will look like when an individual is ready to retire, current expenses should be adjusted for inflation. Unfortunately, no one knows the future rate of inflation, so estimates must be made. The table below provides a multiplication factor for expenses at different rates of inflation. For example, if there are 10 years until retirement and one expects a 5 percent inflation rate, one should multiply current expenses by the inflation table factor of 1.63. A current need of $5,000 per year translates to a requirement of $8,150 per year ten years later — just to stay even (5,000 × 1.63).

In determining the income my parents will have at retirement, we need to add the various components. They will receive $30,000 per year from an annual pension from their employer. There is also Social Security. The amount of the monthly Social Security benefit to which a worker is entitled depends upon that worker's earnings record and the age at which the retiree chooses to begin receiving benefits. Currently, the earliest age at which benefits are payable is 62. Should my parents choose to wait until age 66 — ten years from now — to start receiving benefits, they will receive $1,150 per month, or $13,800 per year. This is a meaningful addition to other income, but hardly enough to live on by itself. Total defined benefit income would be $43,800 per year.

Projecting Retirement Income and Identifying the Cash Flow Deficit

Many experts claim that the average person needs 65 to 75 percent of their pre-retirement income. The best way to determine how much you will need in the future is to understand what you need right now. In retirement, you will need cash inflows to cover expenses and taxes only. Your expenses may change if you change your lifestyle, and your taxes will change depending on whether your cash inflows come from income or a return of investment. Below is a list of expense items and the amounts currently spent on them. The "Future Amount" column reflects the inflation table factor of 1.63, as previously calculated.

When we subtract projected retirement expenses from expected retirement income, we find a negative cash flow — a retirement cash flow deficit. Total expenses at the time of retirement would be $93,725. With only $43,800 in annual income, this leaves a shortfall of $49,925.

One way to make up that shortfall would be to purchase an annuity using other assets. After adding up retirement expenses adjusted for inflation and anticipated Social Security and pension benefits, we still need another $49,925 before taxes — the retirement cash flow deficit. We estimate that this inflow will be needed for 15 years, and we expect the investments to average 8 percent per year.

Using an Annuity to Bridge the Retirement Gap

An annuity is a systematic withdrawal from an investment made periodically as a return of both interest and principal. Under a single-pay annuity, an individual deposits a lump sum and withdraws the same amount each year until the balance is fully paid back. This type — an immediate annuity — is an insurance policy that makes a series of either level or fluctuating payments over a fixed number of years, during the lifetime of one or two individuals, or in any combination of lifetime plus period-certain guarantees. A common use for an immediate annuity is to provide pension-like income to a person who is about to retire. Below is part of an annuity factor table.

We can use this table to calculate how much savings need to be accumulated before retirement. The formula is: Savings = (Annuity Amount ÷ Annuity Factor) × 1,000. Substituting the annuity amount of $49,925, dividing by the annuity factor of 108 (15 years at 8%), and multiplying by 1,000 yields a required savings amount of $462,269. Since they currently have approximately $350,000 in liquid assets and are able to save $10,000 per year, they should have in excess of $460,000 in ten years, assuming their investments do not lose value. This will eliminate the need for my parents to seek any employment after retirement.