Moshe Milevsky, a professor at York University in Canada, has written a lot of articles discussing lifetime income. He is an advocate of annuities, although that is a somewhat controversial position in the industry. (Some argue that the default risk of the insurance company itself is somewhat of a wild card. Hello, AIG.) He discusses annuities in this article from Advisor One too, but what struck me most was just the raw cost of retirement income.
If you are retiring at the age of 65 and would like a $1,000 monthly income stream until life expectancy, which is age 84.2 — after which, I presume, you plan to shoot yourself — and this money is invested at a real rate of 1.5%, then you need a nest egg of a little over $200,000 at retirement. So says the math.
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Now I deliberately selected 1.5% as the investment return in the above paragraph, since it is the best rate you can actually guarantee in today’s environment on an after-inflation basis. Note that in late July 2011, long-term inflation-linked (government) bonds are yielding 1.5%. We all might believe this is artificially low, but it is the best you can get if you want something that is guaranteed. The mighty bond market speaks.
Of course, if you worry about events that have probabilities smaller than 50% — like living beyond life expectancy — and you plan your retirement to the 75th percentile, which is age 90, then you need a retirement nest egg of approximately $251,000. This will generate the $1,000 monthly income for the extra six years. Stated differently, the present value of $1,000 per month until the age of 90 is $251,000 when discounted at 1.5%. And, if you worry about events with probabilities smaller than 25% and you plan to the 95th percentile of the mortality table, which is age 97, then you need a nest egg of $306,000 to generate the $1,000 of monthly income. Big numbers. Low rates.
He includes a table of returns in his article, but anyway you cut it, $250-300,000 to generate only $1000 of monthly income is a lot! Many retirees are planning—or maybe “hoping” is the appropriate word—to retire with the same level of income as they are currently earning.
Many retirees would be delighted to get $6000 per month in income, but turn green when they realize they will need a minimum portfolio size of $1.5 million. One of the big risks this can create, according to Mr. Milevsky, is a thinking error, often perpetuated by some retirement planning software:
Assuming a more aggressive portfolio, in the hopes that you can move to the upper right-hand corner of the table — and hence require a smaller nest egg for retirement — is a mirage. You can’t tweak expected return (a.k.a. asset allocations) assumptions until you get the numbers that you like.
Boosting your expected return by adjusting your asset allocation must also consider the possibility that you won’t achieve your expected return! After all, there is no guarantee of results in any market.
The safest and best way to avoid a retirement shortfall is simply to save more, save longer, and invest better. If your assumptions are conservative and your investment results are favorable, you might end up with extra capital. That’s a high-class problem to have. If your assumptions are too aggressive, you’ll end up like all of the public and corporate defined benefit plans: under-funded. The further you are away from collecting Social Security, the less likely it is you’ll see all of it, so you can’t count on that to bail you out.
It’s time to roll up your sleeves and start saving.
