Retirement Needs Analysis and Goal Setting
Two ways to size the number
Capital needs analysis runs either as a capital-preservation (pure annuity) method, solving for the lump sum that funds an inflation-adjusted spending stream to a chosen age, or as a Monte Carlo simulation that reports the probability of not running out of money. Both depend on the same inputs: spending, inflation, expected returns, longevity, taxes, and other income sources.
The replacement ratio
A workhorse rule of thumb is 70% to 80% of pre-retirement gross income, adjusted for the client. Lower earners often need a higher percentage because Social Security replaces less proportionally. Higher earners may need a lower percentage because work-related costs disappear and the tax system is progressive, but they may need more if they plan expensive travel or face high healthcare costs.
Traps
- Applying the ratio to gross income and then ignoring the taxes due on withdrawals.
- Omitting Social Security and pension income, or double-counting it.
- Comparing nominal returns to inflation-adjusted spending.
- Planning to average life expectancy instead of an age with meaningful probability for a healthy couple (90 to 95).
- Forgetting Medicare premiums, dental and vision costs, and long-term care as separate line items.
- Confusing a goal (a number) with a strategy (how the number is funded).
Worked example
A client wants $75,000 of pre-tax spending. Social Security at full retirement age provides $30,000, so the portfolio must supply $45,000. At a 4% initial withdrawal rate, required capital is $45,000 divided by 0.04, or $1,125,000. If a 3.5% rate is chosen for a 35-year horizon, the requirement rises to about $1,286,000. The same spending target changes the answer by more than $160,000 depending on the withdrawal assumption, which is why the assumption must be stated and defended.