Retirement Planning
Domain 6 tests the shift from accumulation to decumulation: how much to save, how much capital is needed, and how to draw it sustainably. Questions often combine inflation, longevity, and pension income.
Core rules
- Replacement ratio: retirement spending as a percentage of pre-retirement income; 60–80% is a common planning range, but it must reflect actual expected spending.
- Inflation compounds over a long retirement; use real returns or inflate each cash flow.
- Longevity risk is the risk of outliving assets. A couple aged 65 has a meaningful chance that one partner lives into the 90s.
- Defined benefit (DB) pensions promise a benefit; defined contribution (DC) plans depend on contributions and investment returns.
- Annuities convert capital into income and transfer longevity risk, at a cost and with reduced liquidity.
- Sequence-of-returns risk: poor returns early in retirement can permanently reduce sustainable income.
- A common starting point for sustainable withdrawals is 4% of the initial portfolio, inflation-adjusted, but it is a planning heuristic, not a guarantee.
Worked example
A client earns 600,000 and wants 70% replacement, or 420,000 a year. Social security provides 180,000, leaving a gap of 240,000. At a 4% initial withdrawal rate, required capital is 240,000 / 0.04 = 6,000,000, equivalent to 25 times the gap. If the client already has 3,000,000, the shortfall is 3,000,000. Assuming a 5% nominal return and 2.5% inflation, the real return is about 2.44%; saving 150,000 a year for 12 years grows to approximately 150,000 × [((1.0244)^12 − 1) / 0.0244] = 2,065,000. The planner should test a lower return or higher inflation scenario before confirming the plan.
Traps
- Using nominal returns for a retirement need expressed in today's money.
- Underestimating longevity or healthcare costs.
- Ignoring sequence risk and testing only the average return.
- Counting a DB pension without checking indexation and survivor benefits.
- Withdrawing from tax-deferred accounts without considering the tax bracket in each year.
- Assuming the 4% rule fits every client and every market.