The Danger of Simplified Projection Techniques
In my last post I reviewed The Number, a wonderful book that will help you understand the issues in arriving at your own number. It's been interesting to read the book's reviews on Amazon.com. So many of the readers/reviewers really miss the point of the book. The author of "The Number" never intended the book to be a "how-to" on projecting one's retirement needs. It's not about formulas and projections.
A recent reviewer proposed his own formula for projecting the wealth needed by a hypothetical couple. Here are the assumptions he used:
"Let's say you want to retire on $100,000 a year. Assuming that you and your spouse will pull $30,000 a year from Social Security, and $20,000 a year from old defined benefit pension plans; you have a gap of $50,000. As a short cut, you can use the Dividend Discount Model to value stock. Using a conservative after tax investment return of 7.5% and a long term inflation rate of 2.5%, by dividing $50,000 by (7.5% - 2.5%) you need $1,000,000 in your own retirement funds (401K, IRAs) to retire. In reality, you need a bit less because the Dividend Discount Model assumes you live forever."
The true result of this projection is so far off base and really highlights how people can underestimate the wealth they need. I ran a Monte Carlo projection using the reviewer's figures with the couple retiring at age 60. I used the same 2.5% inflation figure and I allowed the pension, social security, and living expenses to grow at this rate. I also assumed a 60% equities, 40% fixed income diversified allocation with an 8.1% average return and a standard deviation of 10.8%. I put 50% of the $1 million of additional retirement wealth in a taxable investment account and the other 50% in an IRA. The result is a 95% chance of exhausting the couple's wealth by age 95. If the retirement is delayed until age 65 there's still an 80% chance of running out of money by age 95. Forget his formula. It will end in financial disaster.
Why was the reviewer's projection so far off base? First, there was no mention of taxes. He assumed that the annual distributions of $30,000 of social security and $20,000 pension and the $1 million of savings would be free of tax. This just can't be. To live on $100,000 per year you need distributions totaling about $150,000 before tax. Second, the issue of volatility is completely ignored. Where do you get a 7.5% after-tax return with zero volatility? Not on this planet.
Seat-of-the pants, back-of-the-envelope projections? Forget 'em. You'll end up in the poorhouse. Or, in your children's spare bedroom.
A recent reviewer proposed his own formula for projecting the wealth needed by a hypothetical couple. Here are the assumptions he used:
"Let's say you want to retire on $100,000 a year. Assuming that you and your spouse will pull $30,000 a year from Social Security, and $20,000 a year from old defined benefit pension plans; you have a gap of $50,000. As a short cut, you can use the Dividend Discount Model to value stock. Using a conservative after tax investment return of 7.5% and a long term inflation rate of 2.5%, by dividing $50,000 by (7.5% - 2.5%) you need $1,000,000 in your own retirement funds (401K, IRAs) to retire. In reality, you need a bit less because the Dividend Discount Model assumes you live forever."
The true result of this projection is so far off base and really highlights how people can underestimate the wealth they need. I ran a Monte Carlo projection using the reviewer's figures with the couple retiring at age 60. I used the same 2.5% inflation figure and I allowed the pension, social security, and living expenses to grow at this rate. I also assumed a 60% equities, 40% fixed income diversified allocation with an 8.1% average return and a standard deviation of 10.8%. I put 50% of the $1 million of additional retirement wealth in a taxable investment account and the other 50% in an IRA. The result is a 95% chance of exhausting the couple's wealth by age 95. If the retirement is delayed until age 65 there's still an 80% chance of running out of money by age 95. Forget his formula. It will end in financial disaster.
Why was the reviewer's projection so far off base? First, there was no mention of taxes. He assumed that the annual distributions of $30,000 of social security and $20,000 pension and the $1 million of savings would be free of tax. This just can't be. To live on $100,000 per year you need distributions totaling about $150,000 before tax. Second, the issue of volatility is completely ignored. Where do you get a 7.5% after-tax return with zero volatility? Not on this planet.
Seat-of-the pants, back-of-the-envelope projections? Forget 'em. You'll end up in the poorhouse. Or, in your children's spare bedroom.
posted by Sherman L. Doll, CPA/PFS at
9:36 AM
