Understanding the Two Sides of the Retirement Equation
It’s enough to make even a number-happy engineer dizzy: savings, expenses, interest rates, investment returns, inflation rates, tax rates, safe withdrawal rates…. I pity the prospective retiree who doesn’t like math!
What are we talking about? The retirement equation: the essential relationships, now and in the future, between all the variables that determine how long your money will last. Fortunes are made by calculating, prognosticating about, and manipulating this formula. And fortunes will be lost by those who get it wrong…
But, despite all the words uttered and pixels consumed on behalf of this equation, it actually boils down to a simple relationship that anybody can understand:
(Your Savings) x (Estimates About the Future) ==> Monthly Income for Expenses
Putting this into even plainer English: all of your savings — cash, investments, retirement accounts, annuities, pensions, social security go into a pot at the time you retire. Then you, or a financial advisor or an insurance company, apply some estimates about what will happen in the future to that pot. And, based on those estimates, you get from your savings pot some amount of income each month to pay your living expenses. In a nutshell, that’s the retirement equation.
Note there are two sides to the equation: savings on the left, income on the right. As you approach and reach retirement, and long afterwards, you will be extremely interested in the right-hand portions of this equation — the Estimates and Income. But long before you can think in those terms, you will, or should be, focused on the Savings part of the equation. That’s the part that you can track and influence during your working years, to create a better retirement for yourself.
I recommend tracking that savings (or net worth) number starting as early as possible in your career, so that you get regular feedback on whether your spending and saving habits are leading you in the right direction, or not. And, you can use that savings number for simple retirement planning too: you can go a long ways toward answering the retirement question based simply on your savings, before introducing the complexities of income and cash flow far into the future.
To start, you need to determine a savings amount that has a reasonable chance of providing you financial security. You’d like to reduce it all down to one number. But first there is a catch: Just about every retiree has an asset that doesn’t easily reduce to a single “savings” number — a pension, annuity, or Social Security — for example.
Your situation might be too complex for a simple approach, but let’s try. For starters, you need to contact the relevant custodian and collect all the information available about your expected benefit: What will it be? When will it start? How often will you get it? Will it change over time? Is it inflation adjusted?
From there you want to determine the present value of your asset — the amount of money somebody would need now to provide that fixed stream of income into the future. Knowing the present value lets you lump that asset into your savings via simple addition.
Calculating present value requires some math, so this could be the point where you consult a financial pro. But the analysis can be performed on any financial calculator, and is potentially straightforward. It’s especially easy if you’ll be receiving a set amount each month. The trickiest aspect may be choosing a reasonable interest rate, but one possible approach is to use an average rate of return for bonds.
The benefit, once you’re through the math, is that you wind up with a single “equivalent” number you can add to your savings on the left side of the retirement equation above. This can simplify both tracking how you are doing against your goals, and figuring out if you’ll have enough to pay living expenses after you retire.
Admittedly this is a rough analysis but, truth to tell, even much more sophisticated approaches aren’t necessarily any more accurate — because of the huge uncertainties in input variables when attempting to predict the future.
Interested in more detail on the retirement equation, or how it applies to Social Security? Sign up now for my free eBook…
- The Best Retirement Calculators can help you perform detailed retirement simulations including modeling withdrawal strategies, federal and state income taxes, healthcare expenses, and more. Can I Retire Yet? partners with two of the best.
- New Retirement: Web Based High Fidelity Modeling Tool
- Pralana Gold: Microsoft Excel Based High Fidelity Modeling Tool
- Free Travel or Cash Back with credit card rewards and sign up bonuses.
- Monitor Your Investment Portfolio
- Sign up for a free Personal Capital account to gain access to track your asset allocation, investment performance, individual account balances, net worth, cash flow, and investment expenses.
- Our Books
- Choose FI: Your Blueprint to Financial Independence
- Can I Retire Yet: How To Make the Biggest Financial Decision of the Rest of Your Life
- Retiring Sooner: How to Accelerate Your Financial Independence
Join more than 18,000 subscribers.
Get free regular updates from "Can I Retire Yet?" on saving, investing, retiring, and retirement income. New articles weekly.