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How to Model the Retirement Income Gap

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The textbook, or fairy tale, version of retirement goes something like this: you work your entire career, until you save your retirement "number," or reach the pension or Social Security age around 65 (later for many boomers). Then, your paycheck stops and your retirement income starts.

This is a convenient fiction for discussing retirement in sound-bite sized chunks. The only problem is that it isn’t realistic for many of us.

That textbook version of retirement features a relatively steady and predictable cash flow: (1) you collect a paycheck for 30-40 years, then (2) you collect a pension, Social Security, or annuity check for the rest of your life. Unfortunately the reality is that many of us in the boomer generation and succeeding Gen’s X and Y won’t experience that steady, fairy tale flow of income in retirement….

Here are just three of the possible reasons why:

  1. You may get laid off or retire early, before a pension or Social Security starts.
  2. You may decide to defer Social Security in order to increase your lifetime benefits.
  3. You may have a spouse who retires on a different schedule, with benefits starting at a later date.

If your situation resembles any of these, then your retirement equation is a bit more complex than the oft-recommended "save some multiple of your expenses" model. Simply subtracting your guaranteed income from your expenses to see if you have enough savings to cover the shortfall, doesn’t cut it, since your income will change during retirement.

If you’re serious about modeling and understanding your cash flow in retirement — knowing if you’ll have enough — how do you handle this kind of retirement income "gap"? Is there really a single retirement "number" you can compute in this case?

First, the bad news. This is going to require some math, or some software tools, and probably a bit of both. Or you could pay a financial planner to answer the question for you. However I’d encourage you to try it yourself first, because the good news is that it is relatively simple. And by taking ownership of your own retirement model, you’ll be in the driver’s seat when inevitable changes happen and questions arise. You’ll be able to tweak the inputs, and answer those questions, quickly, at home. You won’t have to find, schedule, communicate with, and pay a professional, just to understand your financial future.

So, let’s get started. There are two fundamental ways that I know how to look at this problem of uneven income in retirement: cash flow, and present value. Mathematically, they are equivalent. One is not superior to the other, but they do require different tools, and one lends itself better to a detailed analysis, while the other is better as a rough estimate. If possible, use both, at the start. That way you can double-check your own situation, and also form your own preference between the two. That’s what I did.

Cash Flow

This is the easiest technique to understand, but the hardest to perform, without some software support. Essentially it’s no different than balancing a checkbook, but on a longer time scale. So, you start with your current savings, then, for each year of the rest of your life, you simply add in your income and subtract out your expenses. For greater accuracy, you must also add in investment returns for each year, while adjusting your expenses for possible inflation, and taking out taxes.

The main benefits of this approach are that it is simple to understand in theory, and it provides a comprehensive view of your financial life. For each year, you get a detailed snapshot of your financial position, seeing all the inflows and outflows. And this approach can naturally handle an infinite variety of future events — your spouse’s switch to part-time work in 3 years, the new car you expect to buy 6 years from now, the start of your delayed Social Security benefits in 8 years, for example.

The main drawback to cash flow modeling is that it is data and time-intensive. Done comprehensively, there are lots of inputs to be gathered, a great deal of number crunching to be performed (potentially a dozen or more calculations for each year of the rest of your life), and reams of output data. Software tool support of some type is essential.

An electronic spreadsheet like Excel can be a good starting point for this type of simple cash flow analysis. Rows in the spreadsheet represent a year in your life. Columns might include your age, beginning asset balance, income (pension, Social Security, investment, rental), expenses, taxes, net cash flow, and ending balance. This is workable for a simple analysis. However, setting up the formulas for such a spreadsheet model can be time-consuming unless you’re a spreadsheet whiz. Also, comparing different scenarios or modeling advanced situations can quickly become unwieldy.

That’s where a dedicated retirement planning tool comes in. The one I’ve used for years is the J&L Financial Planner. At its core is a simple and powerful financial simulator. First, you set initial conditions such as current savings, expected returns, and tax rates. Next you define a schedule for financial events such as rate changes, deposits, transfers, loans, mortgages, debts, and withdrawals. The program then takes the initial conditions you’ve defined, and applies your events in an annual loop, reporting and graphing account balances and other metrics for each year along the way.

The J&L Financial Planner also offers professional planning features such as multiple accounts, asset allocation, Required Minimum Distributions, Monte Carlo and historic return analysis, Rule 72T distributions, and scenario comparison. The program is offered in several versions, including the entry-level “Regular” version for $80. And you can try it for 21 days before buying. Note, this is Windows desktop software that has been around for many years. There may be some friendlier and more modern tools available on the web (if you can recommend one, leave a comment below), but I doubt there are any more powerful.

Ultimately, what you wind up with from a cash flow analysis, is a long term picture of your net worth, year after year, going into the future. If that net worth stays level or goes up, that’s good. If it trends down, then you are facing a sobering race against the calendar: will your life or your money run out first?

Present Value

If the cash flow modeling described above requires more detail, time, and expense than you can muster right now, what are your options? A simpler approach, though it still requires some tool support, is present value analysis. The concept of present value may be less intuitive, at first, unless you already have a technical bent. But you’ll like the implications: because you can use it to find that single, mythical retirement "number," even though you might have uneven income flows out in your future.

Present value analysis is based on the well-known financial principle of the time value of money. If you have some appreciation for why interest rates exist, or how a bird in the hand is better than one in the bush, then you can probably understand that a future promise of money is worth less than that same sum today, and must be "discounted" back to the present.

This approach simplifies complex future financial events — whether lump sums, or income streams — by converting those future sums of money into a present value — a single number in today’s dollars. From that point the analysis is easy: simply add up all your income as present values. Either you have enough on hand today to cover your expenses with a safe withdrawal rate, or you don’t. In which case you keep working.

The main benefit of present value analysis is that it lends itself to simpler calculations, and simpler output results to manage. In theory you could compute present values for all your future events, just like the cash flow analysis. But, in practice, the method favors a rough cut estimation of just your major future cash flows — such as a pension or Social Security. So, in the end, you are dealing with a just a few numbers.

That rough cut estimation is also the greatest limitation of this approach. It might gloss over the finer points of retirement cash flows and give you a misleading answer that doesn’t adequately model investment returns or inflation or your own life events.

A benefit is that tools for a present value analysis are readily available. Any decent financial calculator can tell you the present value of a future lump sum or cash flow, once you specify the time span and an interest rate. There are numerous such calculators freely available on the web. Here are a couple good places to start:

Once you know your current savings and have determined the present values of any expected future income, you can add them together and find out if you have enough. You’ll wind up with a single number that represents all of your retirement assets. For thoughts on how big that number must be, see Your Retirement Fuel Gauge and the Related Articles there.

What Did We Forget?

So I’ve described two relatively simple approaches for how to model a retirement income gap, or gaps, and find out if your money will last.

But before we wrap up, let me note some critical limitations of either of these analyses — why they only give rough answers, and can even provide a false sense of security….

For starters, such approaches require predicting future inflation, interest rates, or investment returns. You might use a conservative average or current rate of return for bonds, though even that can be problematic. And future inflation is anybody’s guess. The best advice is to pick a range of reasonable rates, highs and lows, and “bracket” your future under the best case and worst case scenarios.

There is another critical limitation. Neither of these approaches alone — either analyzing cash flows or computing present values – accounts for the impact of randomness, the potential variation in sequence of returns for your investment portfolio. They assume that the economy and markets will be consistent, year after year — the same inflation, the same investment returns. But we all know that just isn’t so.

What if the market tanks at the start of your retirement and requires years to recover? Research shows that you must take out "insurance" against such possibilities, by banking some of your investment return each year instead of consuming it. You can’t live on the average return of the market. The more precise answer can be obtained through simulations using historical market data, or Monte Carlo analysis, or a "safe" withdrawal rate. Though — no surprise — there are theoretical limitations to all of these approaches too.

If you’re equipped for those more sophisticated analyses, go for it. But, if not, understand that we’re talking here about a simulation of an ill-defined reality far into an unpredictable future. The basic approaches outlined above — cash flow and present value — are good enough starting points. Just don’t take their results, or any financial planning for that matter, as gospel.

I’ll have more on analyzing retirement scenarios in future posts. If you’re interested in this topic and would like to see a worked example, let me know. And, if you can recommend other modeling techniques or software tools from personal experience, please add a comment below….

Comments

  1. I am sort of combining both of these ideas (I think). Both cash flows and present value.

    Right now I am 36 and plan on evaluating again at age 50. My current investment portfolio is $170,000 or so. My plan is to keep working to cover my living expenses for now, at least until age 50.

    At that time, who knows what the money will be worth? We can make assumptions and take guesses, putting it it somewhere around 300K or so maybe.

    My thought regarding cash flow at that future point in time would be roughly 4% income on the money. I would not want to estimate any higher than that for an income based portfolio. Of course I am just basing this on what financial gurus have told me, etc. I have no real world experience with dividends and cash flows and all that. All I know is that my investments have done something like 11 percent in the last year or so and that is not sustainable, or typical (I know that much at least, right?).

    My wild card is frugality. This is how I create future freedom. My living expenses are right around $1,100/month now but I plan to lower those even further after saving up and buying a cheap but small home in cash (right now I rent). With annual property taxes of under $1,000 in my area, I am confident I can get my monthly expenses even lower.

    I never even considered the idea that I might get SS income some day. Never even thought about it. Probably a good thing, writing that one off, no?

    Of course inflation will peck away at my retirement savings….but I don't have to stop working any time soon either. I don't see a point in trying to add additional savings. Rather, my option is to simply keep working for longer (and letting my investments grow untouched).

  2. What is your opinion of FireCalc as a retirement planning tool?

  3. Darrow Kirkpatrick says:

    Hi Patrick, thanks for the detailed comment. You're right, don't count on 11 percent returns going forward, but you can be be grateful that you got off to a good start. Many experts are predicting below-average returns in the stock market, based on current valuations. I like your "frugality wildcard." I have the same card in my deck. It's nice to live cheaply, and know you could live even cheaper, and happily, if needed. I don't hold with those who argue you shouldn't plan on Social Security. It's a hugely important and popular program. I just don't see it going away. However, at your age, it would be wise to plan on receiving only a fraction of current benefits.

  4. Darrow Kirkpatrick says:

    rjack: I've used FireCalc. It's an important model and was one of the earliest, as I understand, to do simulations based on historical data. A criticism in some current thinking would be that the future might, in fact, be substantially different/worse than the past. So just because a calculator uses 100 years of data doesn't make the results ironclad. I also find the user interface difficult for all but simple scenarios. Bottom line: I'd suggest using FireCalc if you like it, but using other calculators as well.

  5. Bill Raynor says:

    Hi Darrow,
    I am new to your blog (and much of the [early] retirement online community) and have noticed that this literature tends to be light on equations and such. I'm a quant (Ph.D. in Statistics) and know how to code, so where do I go to get the substantive info? I'm not looking to become a C.F.A. or anything, but wish to teach myself the finance and math. (At 63, I don't see myself getting another degree….)

    So, could you please recommend some books/blogs for me?

    Thanks
    Bill

  6. Darrow Kirkpatrick says:

    Hi Bill,

    Welcome and thanks for the great question. For a more technical treatment of these retirement topics, and some of my own favorite sources, check out these authors/researchers and their books and blogs (I've linked to their sites):

    Wade Pfau
    Jim Otar
    Moshe Milevsky

    Regards,
    Darrow

  7. Bill Raynor says:

    Thanks Darrow. These are what I was looking there. And, in a delicious irony, Wade Pfau reported an article from a Tom Cotton about the difficulties of working with a statistician….

    Bill