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Subject:  Re: How to account: pensions vs. cash accts? Date:  1/3/2004  12:41 AM
Author:  babyfrog Number:  38348 of 78663

Hi, Stoffel67,

it seems to me that I can take an anticipated rate of return, subtract inflation, and add that interest along with our expected future contributions to arrive at how much we'll have at our fabled "retirement age". I'm pretty confident on this part here, but feel free to correct me.

In the financial planning training materials that I'm studying from currently, the way that they handle inflation and future dollars is with a division equation. Presume that you expect 8% return on your investments and a 3% inflation rate. The equation to tell you your after-inflation total return would be (1.08/1.03)-1 = 0.0485 = 4.85%. For most values in the range of expected investment returns, your equation, which sounds more like 1.08 - 1.03 = .05 = 5%, would be a decent first cut approximation, but over the life of a long term career, that extra .15% difference in compounding assumptions can make a big difference. The reason why the first equation is better is because you're calculating future dollars against future dollars. In other words, with 3% inflation, because it will take $1.03 in a year to buy what $1.00 will buy today, the $1.08 you hope to have earned by then will only be worth $1.08/$1.03 = $1.0485 of today's spending power.

In engineering terms, I'm trying to figure out how to normalize cash account units to pension units, or vice versa, and which if any is a common practice.

When you retire, instead of working for your money, you will hopefully be in a position where your money will work for you. For that to work, your assets need to through off a cash flow stream, either through asset sales or through dividends, interest, or other cash distributions. Your retirement assets are a means to an end - that end being a cash flow stream able to cover your chosen retirement lifestyle for as long as you're allowed to live on this Earth.

As such, the way I look at the problem is as follows: "If I want a $50,000 per year lifestyle in retirement, then I'll need my pension + social security + retirement accounts be able to pay out a total of $50,000 per year." If Social Security will pay out $5,000 per year, and the pension will pay out $25,000 per year, then that means the retirement accounts need to pay out $20,000 per year. And, of course, inflation doesn't just stop when the paychecks stop, so the basket of assets and pensions needs to be sufficient to handle the ravages of inflation.

On a very much related note, the CPI, the most widely recognized measure of inflation, provides a view of inflation throughout the general economy. For seniors, however, the inflation picture is much worse. While the price of goods may be stagnating, the price of services, especially medical services, is skyrocketing. And in general, seniors tend to have a higher need for services, especially for services of the medical variety, than do younger people. So while Social Security has a Cost Of Living Increase and some pensions do as well, those increases may be pegged to an inflation rate that is not necessarily reflective of the needs of a Senior Citizen.

Well, I might live for 25 years after my retirement, so a monthly benefit of $1000 is kinda worth $X in cash if you account for interest and inflation over 25 years"?

There are two ways to look at that question of a life-long cash flow - a forever account and a draw down account. The draw down perspective says "we're going to die, let's spend it all and die broke". The forever perspective says "we're going to die, but we don't know when, and we'd rather not li