A recent survey indicates that only 1 in 5 people of retirement age know how t0 make their savings last through retirement. Many had never even heard of the 4% savings withdrawal rate that pops up in articles weekly, and many had never heard the term savings longevity.
The savings longevity calculation determines the length of time that retirement savings will last given an annual withdrawal amount (in dollars or as a percentage), and includes an anticipated return on investment or interest on savings rate. It should also include an expected inflation rate, although many calculators omit this important factor.
There are several ways to calculate savings longevity, and each one makes a different set of assumptions. I cover each of them in detail in “Personal Finance Simply Understood”, but for the purpose of this post we’ll look at the method that includes all three factors. A slight change to any one of these factors can make a significant difference since the calculations are performed on large amounts of money and cover a very long period of time.
For the example, the retirement period will be twenty-five years, the annual inflation rate will be 2 percent, annual expenses at retirement will be $78,000, and the retirement savings starting balance will be $2,500,000.
Since expenses will grow with inflation, this approach to savings longevity increases the withdrawal amount in line with the inflation rate to compensate for increases in expenses. We start with the total amount of savings and subtract the inflation-adjusted annual expense amount each year from the balance. This example assumes that the retirement savings amount would be kept in an insured savings account (earning very little interest), so return on investment is not included.
The first and last three years of data for the example are shown below. The annual withdrawal amount increases each year with inflation, and the balance in the account is reduced. As long as the inflation rate remains at 2 percent or below, the savings will last through the retirement period.
Notice the increase in the annual withdrawal amount to keep up with inflation, and that if we need to withdraw more in some years to pay unexpected expenses, then our savings will run out sooner. But again, we have not considered a return on investment, and even a small return will have a significant effect on the balance because of the large amount in savings. The table below shows the return on investment for $2,500,000 in the first year of retirement at different rates of return. This could be a large amount to overlook.
The previous table showed the results of withdrawing an inflation-adjusted amount each year with no return on investment, and the retirement savings balance lasted exactly twenty-five years. The table below shows the number of years that the sample savings amount will last when we withdraw the inflation-adjusted amount but include different rates of return that the savings would be earning.
With a 4 percent return, $2,500,000 in retirement savings will last twice as long as needed. This shows that if we’ll be earning a reasonable return on investment, our retirement savings goal could be much smaller than $2,500,000 and still provide for expenses through the retirement period.
Determining Retirement Savings Goal
- Estimate expenses for the retirement year.
- Apply inflation to expenses over the retirement period.
- Determine the total retirement expense amount.
- Apply a conservative return on investment to the savings.
- Calculate savings longevity.
- Adjust the total savings amount if needed and recalculate.
Once retirement begins, we should review the amounts annually. If the return on investment or inflation rate changes, recalculating the amounts from that date forward will show if we need to adjust our plans.
Thanks for reading.