Retirement always seems to cost more than you think. With the recent market volatility, it may feel like it's costing even more, although comprehensive planning can ease the burden.
Moshe Milevsky, a professor of finance at York University in Toronto, has written and lectured extensively on retirement income issues. He's constantly re-evaluating and fine-tuning optimal funding strategies.
Although there are hundreds of calculators on the market that will give you a number for how much you will need to sustain your lifestyle in retirement, Milevsky says many of these products provide misleading results. They can really throw you for a loop unless you run many different risk, return, and longevity scenarios.
What if average returns are unusually low? What if inflation comes roaring back? What if you live into your 10th decade? Then that "off the shelf" calculation may get you into trouble. "More problematically," Milevsky notes, "they then generate a false sense of security that you indeed do have enough, when in fact you don't."
Milevsky's recent research shows that you need to do some additional number-crunching to arrive at a realistic retirement figure.
The most honest way of coming up with the right number is to look at real, inflation-adjusted returns. This is what you're left with after cost-of-living and taxes nip away at your portfolio performance. Most calculators will give you nominal returns.
Imagine you have a fixed pension and have done the maths on your social security benefits. Let's say you need an additional £1,000 a month in supplemental income. How much you need to obtain that amount depends on life expectancy and rate of return.
In a low-return environment, you'd need about £200,000 to get you that £1,000-a-month payment. That's assuming a return of 1.5% getting you to age 84 (with an investment starting at age 65). If the market does much better, then you'd only need £131,600 at a 6.5% return.
Longevity throws another curve. What if you were to live to age 97? Then you'd need £305,600 at 1.5% return and £161,700 at 6.5%. Compounding definitely helps if you have the time.
As you can see, as you dial down the return expectations, the true cost of retirement becomes apparent. You'll either need to set more aside or consider taking more risk to achieve higher returns, which are never guaranteed in the stock market. The 6.5% return model assumes that you're investing in stocks or stock-based funds and you don't enter lost decades like the 1930s and 1970s--or the last one.
Milevsky says one of the most common errors on the risk/return calculation is the failure to take into account the possibility that you won't reach your projected goal. What if the current market malaise is part of a global retrenchment in stocks that will provide meagre returns for the next decade? It's possible.
"If you're going to assume a higher return," Milevsky adds, "you must allow for the possibility that things might not work out and you might earn less than expected."
You're probably looking at all of this and saying, of course I know the trade-off between risk and return, but how do I plan for longevity and inflation? Milevsky recommends a combination of funds, annuities, and longevity insurance.
Longevity insurance is a hybrid product that only pays out after a certain period of time. Some products don't pay out until you reach age 85. While there are only a handful of these vehicles on the market, they do help address the fear of running out of money. There are no solid guidelines for estimating life expectancy, but most people seem to underestimate how long they might live. Age of parents at time of death is generally one rule of thumb. (To learn more about longevity risk and insurance, click here and here.)
Another approach to make your money last is an inflation-adjusted annuity, which is indexed to the cost of living. If you spend £230,000 on such a product, it can provide you that £1,000 a month in income without investment risk. "You don't have to assume how long you will live or assume what your portfolio will earn over the random horizon of retirement," Milevsky states.
The bottom line is that every form of protection has its cost. Inflation-adjusted annuities--or any product with enhanced income guarantees--will have either higher expenses or lower benefits. (For more on annuities, see Christine Benz's recent article Four Strategies for Combating Low Annuity Yields and video report Five Questions to Ask Before Purchasing an Annuity on Morningstar.com, the U.S. sister site of Morningstar.co.uk.)
And if you have long-term care insurance or supplemental health policies with inflation coverage, that's another layer of expenses. You also need to be honest about taxes and future benefits from social security. The way things are going, benefits may be reduced and taxes raised to cover long-term budget and social programme deficits.
The best planning involves putting a number of scenarios on the table and filling in the largest gaps. You may not be able to cover everything, but at least you can avoid some catastrophic shortfalls. People are living longer and will need much more money in their old age. The United Nations estimated there were close to half a million people who were at least 100 years old in the world in 2009. While that would be a pleasant surprise for most, it shouldn't be an unpleasant surprise financially.
John F. Wasik is a Morningstar columnist and author of 13 books, including The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream. The views expressed in this article do not necessarily reflect the views of Morningstar. This article has been edited by Holly Cook, editor of Morningstar.co.uk.
