How much should you be saving to meet your goals? At your current path, will you run out of money before you die?
These are difficult questions to answer because they involve layering cascades of uncertainty:
- You can't know how long you will live.
- You can't know precisely what expenses you will have in the future.
- You can't know what returns you will be able to generate on your savings.
This makes it almost impossible to navigate one of the core tradeoffs at the heart of retirement planning. Spend too much now, and you might die poor, but put off that spending too long and you might never get to enjoy the fruits of your labor.
When dealing with questions that involve huge amounts of uncertainty, there are three approaches that can help:
- Use battle-tested rules of thumb
- Use sophisticated quantiative methods
- Purchase insurance
Each of these has a role to play in building a rational retirement strategy.
Retirement Savings Rules of Thumb
Rules of thumb can have value in situations where lots of uncertainty is present because they can reflect battle-tested wisdom that has survived through a variety of different market environments. A good rule of thumb will not necessarily represent the "optimal" solution, but it can lead you towards a sufficient solution that meets your needs.
Of course, there are bad rules of thumb too. It is always good to apply more rigorous quantiative methods to test the rules of thumb and make sure that they will stand up in different kinds of environments (see below for more than that).
A few retirement savings rules of thumb that are handy (no pun intended) to keep in mind:
- It is generally considered safe to withdraw about 5% of your wealth during retirement
- Many people can get by on 2/3 of their pre-retirement income during retirement
- You can expect money that you save now to double in value in real (inflation-adjusted returns) about every twenty years
Monte Carlo analysis is a more rigorously statistical way to directly evaluate the question: What is the chance that my money will run out before I die? The great value to monte carlo is that you can plug in different assumptions about your level of savings and withdrawal rate during retirement, run thousands of different simulations of what investment returns might look like in the future, and get a bottom-line result that answers that question to the decimal-point. The disadvantage is that this answer can be fairly sensitive to changes in all kinds of assumptions. For more on Monte Carlo analysis, see "Understanding_Monte_Carlo_Simulations."
The Value of Insurance
Through the intelligent design of a savings and retirement plan using rules of thumb and monte-carlo analyses, it is possible to reduce the uncertainty involved in the retirement process, but it is not possible to eliminate it altogether without a very restrictive savings and investment plan. Few people's best-laid plans would stand up to a scenario where they retire at 65, live to 115, and go through a 30 year bear market in between, but of course such a scenario has a finite if small possibility to it.
One way that you can remove just about all uncertainty is through the purchase of insurance. The way that most people do this is to convert their savings at the time of retirement into an annuity. An annuity is a financial instrument that is usually sold by an insurance company that pays you a guaranteed fixed-sum amount every year for the rest of your life, however long that may be. This removes all of the "longevity risk" (change that you live much longer than you expect) as well as the investment risk (chance that a bear market wipes out your income) that you face (so long as the company providing the annuity doesn't fail...). The way that this works for the insurance company is that they can calculate the expected life expectancy of an overall population better than they can of an individual, so it is essentially a form of group insurance.
Of course, annuities are not without their costs. One "problem" with insurance is that it pretty much almost always has a negative expected value to the consumer. In other words, you will very likely lose money by purchasing an insurance policy, otherwise the insurance money could never make any money and would go out of business. The negative expected value of most annuities is compounded by the fact that they sometimes come with a huge sales commission to the broker or salesman you are dealing with. This is just wasted money that you will never get back again, so if you do decide to go the life insurance or annuity route then make sure you are dealing with a reputable and low-cost firm.
Another problem is that with the current rock-bottom interest-rate environment, it is very difficult to get any compelling value out of an annuity. Standard annuities will provide you with no protection from inflation, and real annuities will guarantee that you get basically no real returns. So the insurance does not come at a cheap price...
Whether insurance is worth these fairly steep costs anwyay is largely subject to your own risk tolerance and something that you should work out for yourself or with the help of a financial advisor who is incentivized to put your best interests first.
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