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Author: babyfrog Big red star, 1000 posts Old School Fool Home Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75336  
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 12:41 AM
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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 live out our last days in destitution."

The draw down version provides a higher initial cash flow, but the assets are scheduled to be reduced and eventually extinguished. The forever version provides a lower initial cash flow, but the assets are scheduled to last long enough to be passed on to heirs. In reality, the longer one expectes to live in retirement, the closer the two methods become. For example, let's take a hypothetical person with $500,000 in assets, no other form of cash flow, and a world without inflation.

If that person can earn 5% per year on those assets, that person can take out a $23,809.52 payment at the beginning of every year, forever, from a forever account and never run out of money.

If a person who retires at 67 expects to live to see 92 (25 years), that person can view the assets as something to be drawn down, instead. With the same assumptions as above, but a desire to draw the assets down to zero at death at age 92, the person can take $33,786.88 at the beginning of each year, and run out of money after 25 years. Which is all fine and dandy if one plans to die at age 92 or earlier, but if a person happens to live to see 100, those last eight years will be painful...

In this example, the draw down account paid out about about 41.9% more than the forever account, but the higher initial cash flow needs to be balanced with the fact that at age 92 the money is gone, and finding work at that age is not an easy task... The difference shrinks dramatically the longer a person expects to live in retirement. Take the same hypothetical person in the same fictional world, with the same $500,000 assets, the same 5% expected return, and the same life expectency of 92. Only instead of retiring at 67, this person takes advantage of a generous company's early retirement package and leaves at 47. Now, instead of 25 years in retirement, this person is looking at a 45 year retirement.

The forever account will still pay out the same $23,809.52 at the beginning of every year. The draw down account, however, will only pay $26,791.30 at the beginning of every year. So by anticipating an extra 20 years of retirement, the difference in payments drops from 41.9% to around 12.5%. And the draw down account will STILL fall to zero at age 92, whereas the forever account will still have $500,000 in it at age 92, in case the person happens to live longer.

Personally, I have no idea when I'll die, but I hope it doesn't happen for a very, very long time. I hope to retire early, if at all possible. I'm also quite conservative with my estimations, so I prefer to think and plan for my retirement with the 'forever' account model.

---------

You can certainly choose whatever model you'd like, including some that I haven't mentioned here (such as the "Safe Withdrawl Rate" model they discuss ad infinitum on the "Retire Early Home Page" board). My point was not to dictate the path you must take but rather to share with you my personal perspective and practices on the issues you raised. I hope it was at least minimally helpful.

Best of luck to you,
-Chuck
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