Last Updated Sep 9, 2010 10:56 AM EDT
Learning how an actuary meets this challenge is like discovering what a credentialed nutritionist eats. You can learn a lot just by finding out what an expert does for himself or herself.
A good friend of mine -- Ken Steiner -- recently retired from the prestigious actuarial and consulting firm Towers Watson, where he was in charge of the company's actuarial research department. Over the years, Ken gave a lot of thought to the challenge of generating a lifetime retirement income, and he invented a simple tool that builds on his substantial experience with analyzing retirement programs. He used this tool to help with his own retirement, and now he's sharing it with others through a website called How Much Can I Afford to Spend in Retirement. It contains a simple retirement income calculator and text that describes his approach.
To use Ken's method, you'll need to make a few key assumptions about your future:
- How long you'll need retirement income, i.e. your expected length of retirement
- The rate at which your retirement nest egg will grow, considering both appreciation and income
- Your expected inflation rate or, in other words, what percentage you need to increase your retirement income each year to cover the cost of your living expenses
Once you input all this information, Ken's program calculates how much you can safely withdraw for the coming year. The program calculates this amount in such a way that if all the above assumptions exactly match your actual future experience regarding investment return and inflation, then your money will run out by the end of your (expected) life.
But since you can't count on your assumptions to exactly match what will happen in the future, each year you should recalculate your withdrawal amount for the following year and, if necessary, make adjustments in your assumptions. Most important, you'll update the amount that remains in your retirement savings. And you'll do this every year during your retirement in order to make sure you're withdrawing enough to cover your expenses, but are leaving enough to continue to generate enough income to last throughout your retirement.
This constant adjustment of the withdrawal amount is one of the advantages of Ken's method. Other methods of calculating safe withdrawal amounts lock you into a fixed withdrawal amount without recognizing what's happened to your investments, which doesn't make any sense to me.
The assumptions that you input into Ken's program are critical; you can outlive your money if you're too optimistic about your investment return or if you live longer than your expected length of retirement. You can minimize the odds of outliving your money by being conservative in your assumptions.
In my next post I'll discuss the appropriate assumptions in more detail, and I'll take Ken's program for a test drive to see how it compares with conventional wisdom regarding safe withdrawal rates.