Methuselah, as per the Hebrew Bible, has lived longer than any other person in history to a ripe old age of 969 years. It is believed that over the centuries, his longevity gene has been passed on to his descendants, although it only expresses itself in some individuals. When this gene finds its expression, that person has the potential to live up to 969 years as Methuselah himself. The chosen ones have lived their long lives by not attracting much attention in various continents.
Astoundingly there is one such person in the San Francisco Bay Area and that too he happens to be your colleague, an IT professional. Coincidentally he too is named Methuselah by his parents, as if the gene’s intention and purpose hinted their way into the imagination of his parents. His recent visit to his doctor’s visit for an unrelated condition revealed this longevity gene in him. He is currently 50 years old and was planning on retiring next year, but he is now too stressed out to even think about it after this discovery.
He has discussed his problem with several Finance professionals.One Financial Analyst,who couldn’t get his head around the situation, told him that he shouldn’t retire unless he has a billion dollars. Another one said that since his remaining life expectancy may be 919 years, some 30 times an ordinary mortal, he needs 30X what an average person needs.
Can we help him out? You too are a 50 year male with an estimated lifespan of 30 more years. Can you figure out how much larger than yours does Methuselah’s nest egg need to be? Let’s assume that both you and he are equally good investors, i.e. your investments are expected to have a same (Return on Investment) ROI. Let’s plug in some numbers into the neat calculator at the following link and see what values we get.
Inputs (3 scenarios):
Current Age: 50
Retirement Age: 51
Tax Rate: 25%
Yearly Expenses: $100,000
(Inflation, ROI): (2%, 10%), (2%,6%), (3.5%, 5%)
|Incr. Funds Reqd.||Infl: 2%, ROI:10%||Infl:2%, ROI:6%||Infl:3.5%, ROI:5%|
- IftheROI is high 8% over inflation(which S&P 500 has done over the last three decades) then he needs only $170K more. Wow!!!
- If theROI is reasonable 4% over inflationhe wouldneed over a million more.
- However, if the ROI is only 1.5% over inflation, which we suspect will be the case for most investors going forward, he would needabout $6 million more.
Note: When we say x% over inflation produces such and such result, we are speaking loosely in approximate terms. You would get one result if you assume 2% inflation and 6% ROI than when you use 3.5% inflation and 7.5% ROI, even though both are cases with 4% over inflation, but in relative terms they would be close enough.
When ROI is high how long you live becomes a non-issue, but when ROI is low long life can be expensive. Even a percent or two of excess performance can alter the funds required to retire dramatically. Expecting excess returns over long term is unrealistic however.
Looking at the graph below, we can get a better sense of this phenomena.
This precise scenario of low returns and longer lifespans will be the curse that most Americans will likely face going forward for next few decades. To grasp the magnitude of a problem, we need to measure it. We have so far only investigated the impact of a couple parameters, namely Lifespan and ROI on the size of the nest egg. In order to obtain a better approximation, we need to introduce few more parameters/variables.
Fine tuning the Inputs:
Typically one uses a retirement calculator of some kind to figure this out. The answer one receives is only as good as the inputs provided. This article attempts to give some guidance in regard to these inputs.
In shortmoney is expected to grow at an assumed Rate of Return while getting depleted by rates of taxation and inflation during one’s life. One hopes thatthe money outlasts them.
Typical inputs may look as shown under the column “Simple”, referring to the simple model. Placed next to the typical inputs (that is values for the parameters or variables as we have referred to them)are the suggested inputs where we feel a change is warranted. At the bottom of the table are the results shown as Funds Required.
As yearly expenses vary from person to person and place to place a round figure of $100,000 is used to make it easy to estimate their Funds-Required by altering the expenses accordingly. If you expect your expenses to be $50,000 all you need to do is reduce the “Ongoing Needs” number shown below by 50%. However we do not recommend altering (Long Term Care) LTC fund and Unexpected Expenses based on your estimated yearly expenses as they would not decrease proportionately.
|Rate of Return||6%||5%|
For someone with $4,000 Social Security Monthly benefits and $100,000 yearly expenses the funds required would be as shown below. For a change of $1,000 per month in SS benefits the amount changes by about $200,000.
|Long Term Care||$0||$300,000|
|Tot. Funds Reqd.||$1,953,000||$4,444,000|
In case you are wondering if the funds required include the value of the home, it doesn’t. However when you proverbially kick the bucket, your house belongs to your estate, so from that respect as you wouldn’t be using up all the funds, Funds-Required is being somewhat overestimated though not by the full value of your home. It would be reasonable to reduce the Funds-Required by about a third of the value of your home to bring it closer to the actual value. If your home is worth $1.5 million, you may reduce Funds-Required by $500K bringing the amount to a wee bit below $4 million.
Appendix A: Detailed discussion of the suggested inputs:
Life span Assumption (80 vs. 100):
The calculation of how long you need the money to last is based on your lifespan. Lifespans continue to increase, according to SOA report. In the past half-century, life expectancy for newborn American males improved by an average of almost two years each decade, from 66.6 years in 1960 to 75.7 years by 2010. For females, the average increase was about 1.5 years per decade, from 73.1 years in 1960 to 80.8 years by 2010.
More insidious than ignoring growing lifespans is the mistake of using the average lifespan as the input number. Would you drive a car that has a 50% chance of breaking down while driving to work? Wouldn’t you want it to get you to work with a 99% certainty?
You can find the 95 and 99 percentile figures here:
For a male of average health who is 50 years old, the 95 percentile for incremental life span is 47 years and if he is on the healthier side it is 50 years. If you are married you should consider the lifespan of the last survivor. The 95 percentile for the last survivor is 51.
Assuming lifespan of 100 instead of 80 the Funds Required jump from $1,953,000to $2,247,000
If you are a person who says, “I don’t want to die rich, I can’t take it with me!”, then you may be wondering if you really need to plan for such a long period and if there is a way to get away with saving less. This is called reduction of longevity risk. Well technically there is, but is it the right choice for you? You need to decide. One way would be to purchase an annuity that would pay you benefits until death. You can be certain about the payments and can feel comfortable that you are not leaving money on the table. However, they don’t come cheap. The amount you need to protect yourself with annuities often comes out to be even more than the funds we have estimated you would need to cover yourself until the age of 100 as the underlying interest rates they offer tend to be lower than what you may potentially earn in the stock market.
However annuities may still be appropriate for people that are risk averse and would like that certainty. See the Appendix A at the end for further discussion, if interested.
Inflation rate 2% vs GDP growth rate 3.5%
Using Inflation rate as the deflator is probably the most common error, especially for folks wanting to retire early. You may expect your needs to go up with inflation, but in reality they go up by a greater degree. We propose using expected nominal GDP growth rate as the deflator to reflect increasing standard of living and new necessities that arise over time.
As the economy expands in a few decades several new necessities will be forced on to you. Microwaves, Cell Phones, Fax Machines, Internet, personal printers have all become necessities in a lifetime. Before the days of the cell phones shopping malls had pay phones that you can use to call someone in an emergency. They don’t exist anymore. So even if you are willing to live with only things you had in the past, it may not be n option for you.
What then is a reasonable deflator? Nominal GDP growth is probably a decent proxy for this. GDP growth is comprised of Inflation, Population growth and Productivity improvements. Since US population is flattening out, we can expect GDP growth to track inflation + productivity improvements. Productivity improvements are likely to be around 1.5%. It is hard to know what the inflation will be but if we are assuming to be 2% the appropriate deflator for our calculations will be 3.5%.
So, plugging 3.5% instead of 2% (for inflation) the Funds Required move up to $3,190,000.
Rate of Return Assumption (6% vs 5%):
We were assuming 6% as the rate of return in our Simple Model. Based on our past history of the stock market 8% or higher may seem reasonable and 6% may even seem too conservative. But let’s examine this a bit.
A reasonable estimate of stock market returns in the long run can be approximated by the equation:
Stock Market Returns = Nominal GDP growth + dividends + P/E expansion.
Nominal GDP growth = Population growth + Productivity growth + Inflation.
Next few decades the population in US and much of Western Europe is expected to flatten out. What we are left with then is productivity growth which we may expect around 1.5% and inflation, admittedly difficult to predict, of about 2% which FED seems to be striving for. This brings us the Nominal GDP growth of 3.5%.
Dividends S&P 500 historically have been around 2%.
Many value investors have been warning that the current P/E ratios are unsustainable in the long term and that they are a result of present low interest rate environment and that they would revert back to lower values in the future. However there are those that argue that this low interest rate environment is the new normal as a fall out from the excesses of the previous decades as well as the aging of the developed world. If one were to look at Japan which experienced similar forces, one can’t be too optimistic about the stock market growth. In the absence of a crystal ball, let’s assume that the PE ratios will remain constant.
So 3.5% GDP growth and 2% inflation will bring us to 5.5% stock market return and since one wouldn’t hold 100% of their assets in the stock market, more than 5% is not realistic return on the overall portfolio.
Charles Schwab’s site has following estimates for what to expect in terms of future returns which we think are a bit too aggressive but should give you a decent idea of what the investment world is expecting. You will certainly notice that they are lot less than the historical results.
Note that even if stocks or some other asset were to return more than 5%, since no one can consistently predict which asset class outperforms, one should assume that their portfolio would underperform the best asset class. Besides it would be fool hardy not to maintain some cash or conservative investments.
If we reduce the ROI from 6% to 5% theFunds Required jump to $3,844,000.
Long Term Care Expenses:
As people are living longer more and more people are affected by disabilities that require long term care either in the home or in a nursing facility. The type of disability that prevent you from performing your normal daily activities like, eating, bathing etc… without assistance are called PADL (Physical Activity Daily Activity) disabilities. PADL affects people as follows:
20% of people over 70 and 50% of people over 85 are affected.
You would need to set aside funds for possible long term care expenses. There are many products out there that offer Long Term Care Insurance. Most of them have restrictions on how long they pay and in what conditions trigger and whether it would be in a nursing facility or at home and so on. These products are somewhat controversial, and require sufficient research to find one that you can be comfortable with. One option is to self-insure or in other words save enough.
Without being too precise in order to cover additional long term care expenses based on various estimates for premiums in different articles and working backwards it is probably reasonable to set aside $150,000 if you are a 50 year old single person and about $300,000 if you are married and trying to cover both of you. Our number moves up to $4,144,000.
Throw in some unanticipated expenses, like your children needing some help or someone suing over some negligence and so on, we are staring at a $4.5 million figure.
A question often asked is, “Is this including your home or excluding your home?” The answer depends on whether you estimated your annual expenses, in our example of $100,000, considering home ownership or renting. If you need $100,000 a year even after owning a home, then the amount we have come up is in addition to your home. However when you are ready to proverbially kick the bucket you still own your house, therefore the Funds-Required is overestimated somewhat.
APPENDIX B: Annuities
An article on inflation adjusted income annuity
An inflation-adjusted annuity aims to solve the problem by giving you an automatic cost-of-living increase every year. But the cost is steep. A $100,000 inflation-adjusted annuity policy from Principal Life Insurance offers a $379 monthly payout for a 65-year-old man; American General offers a $363 monthly check.
Immediateannuity.com has the quotes you may want to refer to.
Joint Life with 20 year certain for 50 year old female and 54 year old man $3720 before tax if one invests $1 million. That means they would need to invest about $3 million to guarantee $100k per year after tax (assuming 25% tax rate). This does not protect against inflation.