Monday, July 20, 2009

Calculating how much you will need in retirement: Factoring Inflation

An old friend bought me a book about tackling the subject of how to approach the last third of your life – great book – chock full of humor and usable tactics to employ in the battle against age. I recommend everyone read it. Frequently. Because there is a lot of good advice in it and, if you are at all like me, some of it is bound to fall out of your head from time to time. The name of the book is “Younger Next Year*“*, by Chris Crowley and Henry S. Lodge, M.D.

There is some real-down-to-earth advice on just about every aspect of living the last half or last third of your life. Some of the most useful and sobering can be found in chapter thirteen: Chasing the Iron Bunny. In this section the authors declare matter-of-factly: “There’s one change that hits in retirement that you cannot duck and that you must prepare for as early as possible. There’s less dough“. The statement itself is not particularly insightful but awesomely important because the fact is so often and so easily overlooked by too many of us.

What is particularly impressive is the advice the authors provide on calculating how much you will need in retirement. Here is a brief breakdown:

1. “Make a realistic estimate of how much income per year you are going to have in retirement.”

2. “Unless your income is inflation-protected, adjust it downward by five percent.”

3. “Assume things will be worse and adjust downward another five percent.”

4. “Take a hard look at your prospective sources of income. Calculate coldly how reliable they are and make appropriate adjustments.”

The chapter goes on to help us approach and cope with living on a fraction of what we are currently accustomed to. I will be visiting the points above and use them to help us develop a financial strategy toward retirement and throw in some recent history to view different scenarios.

First things first, it is critical that your income source includes investments whose returns outpace the rate of inflation. The rate of interest earned on a five year CD currently does not provide the edge required. I suggest you extend the length of the accumulation phase, as the longer the accumulation phase, the higher the rate of interest gained.

Be conservative in your calculations. Assume a longer retirement horizon. People are living longer these days. If you follow the book’s instructions, you will be living a whole lot better longer.

If you purchase a 10 year CD instead of a five year CD you can gain up to a full percentage point in interest. If you purchase a fixed income annuity you can gain up to 5 percent more and can even decrease the length of the accumulation phase if you wish. Even in poor performing market periods, your FIA will protect your income against inflation. If the market performs well your FIA will outperform any CD.

If you follow the advice of the authors, the downward adjustments you need to make in compiling a realistic estimate of how much income per year you will need in retirement are drastic. But they need to be. Inflation alone eats away at retirement income value and recent history tells us just how precarious our nest egg is when tied to market performance.

Above all else, protect your principle.

In the coming articles we will discuss, among other things, a comparison of possible retirement income sources and an evaluation of the reliability of each. We will also discuss just how important it is to speak with a financial advisor.

To cite the authors of “Younger Next Year” once more: You do not want to be swimming away from the wreckage at seventy. You need to talk to someone and start planning as soon as possible. At the very least, start doing some research on your own. Visit the LHTR Planning section to begin.

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