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How to plan for retirement when unsure about your future life expectancy

Saving for retirement is tough. What you might not realize, though, is that spending your retirement money is also tough - at least, planning a sustainable strategy for retirement spending is.

Investment returns and the future cost of living are big enough uncertainties, but the greatest difficulty is not knowing how long you will be retired. This is a challenge because time has a huge impact on how much money you will need.

Saving for retirement when time equals money


When you sit down to figure out how much you need to save for retirement, one problem is not knowing how many years of retirement spending you need to fund. The average life expectancy in the U.S. is 78 years, but this average is pulled down by peopled who die young. If you make it to the traditional retirement age of 65, you can be expected to live not just another 13 years (to 78), but for an average of 18.7 years.

These figures are a moving target. In 40 years from 1970 to 2010, the average U.S. life expectancy increased by 7.5 years. So, if you are a 25-year-old, there is no telling what your life expectancy might be by the time you reach retirement age in 40 years.

Remember too that even if life expectancy figures were not so hard to pin down, these numbers are just averages that do not tell you with much accuracy how long you will actually live. Because they are averages, it means that roughly half the people will live longer than the typical life expectancy, which from a retirement funding standpoint means needing more money.

Another important aspect of the relationship between time and the money needed for retirement is that with every year, inflation will take another piece out of the value of your money. If you assume a 3 percent inflation rate, this impact might seem subtle from year to year, but at that rate, it would cut the value of your money in half every 24 years.

Planning your retirement spending

The following are four common methods to plan for retirement spending when you are unsure of your future life expectancy:

  1. Budget-based spending. One method of planning retirement spending is to make assumptions about your expenses based on your expected lifestyle, and budget to spend a certain amount each year. However, the problem with a fixed amount of retirement spending is that if your investment returns do not keep up, you will start drawing down your savings. As your savings diminish, your spending will become an increasingly large percentage of those savings, making it even harder for investment returns to keep up. Unless you start out with a particularly large nest egg relative to the amount you spend, this is likely to result in you outliving the money in your savings account.
  2. Harvesting investment gains. To avoid the above problem, you could simply spend the investment gains you make every year, but unless you are in very conservative investments, your returns are going to be very unpredictable from year to year, and sometimes they might be losses rather than gains. As a practical matter, you cannot simply suspend spending after a bad year, so this is not a reliable approach.
  3. Living on investment income. Income can be more reliable than total returns on investments, but while income may produce positive returns, recent years have seen those returns diminish as savings account rates and bond yields have slid towards zero.
  4. The 4 percent rule of thumb. Financial planners have long used 4 percent as the portion of savings that you can spend annually and have your investment returns generally replenish your spending and keep up with inflation. However, low yields in recent years have made even 4 percent a bit of a stretch, so you might want to aim for lower spending than that or face seeing your savings diminish over time.

Because guaranteed returns these days are meager, and higher returns are unpredictable, there is no best-of-both worlds approach to planning retirement spending. The only way to deal with uncertainty is to be flexible.

Try to set a spending budget that is a low percentage (i.e., less than 4 percent) of your retirement savings. However, if you have investment success, don't automatically raise your spending in line with the portfolio's growth because you may need to keep some of that growth in reserve against future setbacks.

Conversely though, if your investments do not do well, you should be quick to adjust spending down in line with any portfolio losses, so that spending does not grow to be a disproportionate percentage of your savings.

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