How to Predict the Future Part 1

by 4P and Mr. C

That’s right – predict the future! Ok, this method won’t help with lottery tickets, horse racing, stock prices or anything else that will make you rich quick, however it does apply to retirement planning, particularly with predicting the future values of your retirement income and retirement expenses which of course is all you need to calculate to predict your retirement. Planning your retirement is not as simple as tying your shoes but it’s not so complicated that you have to pay an advisor thousands of dollars to figure it out for you.

Everyone has heard all the scary stories about how you will need one million dollars to retire, or two million…or whatever. These numbers sound unreachable for someone who might only have a retirement portfolio of $100k (or no retirement portfolio for that matter) but it’s important to remember that these are future dollars. One million dollars in twenty years is the equivalent to $560,613 dollars right now assuming 3% inflation. This is admittedly still a large number but it’s a lot less than a million dollars.

In the past, to calculate my retirement scenario, I had assembled a complex retirement spreadsheet that involved using the future value of all contributions, withdrawals, taxes, income etc. This worked reasonably well except that it was complicated and didn’t lend itself to change very easily. One of the things I learned from Four Pillars of Investing was to calculate retirement scenarios using today’s dollars to greatly simplify things. The way this is accomplished is to subtract your estimated inflation rate from your estimated portfolio return to get a “real return” and to use today’s dollars for everything else such as portfolio contributions and anticipated withdrawals.

I’ve created a relatively simple retirement scenario in the spreadsheet below, which is for someone (Bob) who is turning 40 this year, has a $250k portfolio and contributes $10k per year. He desires $45k of gross income in retirement at age 60. His expected investment return is 7% but I will subtract 3% inflation to get a real return of 4%. We will also assume that he will get no other income other than from this portfolio and that contributions are made at the end of the year. He will retire at the end of the year in which he turns 60. The goal of this exercise is to determine if he is contributing enough to meet his goal of $45k (in today’s dollars) gross income in retirement. We will also use the “4% rule” which basically states that the initial annual withdrawal from a retirement portfolio should be 4% of the portfolio. This will be discussed in many future posts as it is a particular favourite subject of mine!

If you check out the spreadsheet you will note some interesting things. By age 60 his $250k portfolio has grown to $889k in today’s dollars. Twenty years from now that portfolio will actually be $1,654,516 in year 2027 dollars. This sounds like an incredible amount but it isn’t enough to meet the Bob’s requirement of $45k gross income in today’s dollars. I calculate the portfolio each year by multiplying the previous year value by 1.04 and adding the contribution to that.

As you can see at the bottom of the sheet, 4% of $845k is only $35,575 which falls far short of Bob’s expected gross income.

Tomorrow we will look at a couple of solutions for Bob so he can achieve his goals.

How to Predict the Future Part II

Retirement I

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{ 6 comments… read them below or add one }

1 Brian Poncelet, CFP

As one reaches their goal of one or two million. Don’t forget life insurance! Assuming capital gains will be with us for awhile, a large tax bill will be paid by the people left behind. For some this is not important.

Generally, it is cheaper to get the insurance than it would be to pay the taxes! This is very important if one has a cottage or real estate in general.

2 FourPillars

Brian, insurance can play a part in estate planning but it depends on the individual. My plan is not to leave much other than the family home so it’s not worth it in my case.

Mike

3 FinancialJungle.com

Its a great recommendation to knock inflation off your expected nominal return. It simplifies the math a great deal.

4 FourPillars

FJ – it was quite an epiphany when I discovered that trick. For the simple examples I’ve shown so far, it doesn’t really matter which method you use, but once you add in other income streams and try to calculate income tax, it really simplifies things.

Mike

5 Deborah

Hmmm, and I wanted $60k in today’s dollars. Challenging to say the least…

I’ve read the old theory of 7% per year and how it was downgraded to 4% after a few bad crashes. I think that I can do well with investments that I’ve set my calculation to a 6% withdrawal rate for retirement.

6 FourPillars

Deborah – the “4% rule” is just a guideline. I think you can get away with taking out more than 4% as long as you are flexible – ie in a bear market you should cut back a bit.

Also – I haven’t covered other factors such as CPP, OAS and income splitting. These make a big difference.

Mike

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