RETIREMENT PLANNER In response to a reader's request, I have written a program based on Michael E. Leonetti's article, "Retirement planning: A step-by-step approach," which appeared in the April 1986 AAII Journal. The retirement planning method as outlined by Mr. Leonetti is quite involved and so, too, is the program that implements it. You can hand-enter the program listed on pages 6-11, but then you must make sure to test it against the sample case (based on Mr. Leonetti's example) I will be unfolding here shortly. You would be better off, however, calling up the AAII Electronic Bulletin Board (312/280-8764) and downloading the program (it goes under the names "RETIRE.BAS," "ARETIRE.BAS," "CRETIRE.BAS," "MRETIRE.BAS," and "RETIRE64" for the IBM PC and compatibles, Apple II, Kaypro CP/M, Macintosh, and Commodore 64/128 respectively). If you don't have a modem yet, perhaps the ordeal of hand-entering and debugging such a lengthy program as this will convince you it's high time you purchased one. When you run the program, the main menu displays a number of options (see Figure 1). Figure 1 ********* RETIREMENT PLANNER ********** 1> SPECIFY GENERAL PARAMETERS 2> SPECIFY ANNUAL EXPENDITURES 3> SPECIFY NET WORKING CAPITAL 4> SPECIFY PRE-RETIREMENT CASH FLOWS 5> SPECIFY POST-RETIREMENT CASH FLOWS 6> INSPECT AGE/TIME TABLE 7> COMPUTE COMPOUND GROWTH 8> COMPUTE CAPITAL REQUIREMENT/SURPLUS First, specify the general parameters (see Figure 2). Using Mr. Leonetti's example, "Spouse A" refers to "John," "Spouse B" refers to "Mary," and their ages, years to retirement, and expected mortality ages are as shown. The marginal income tax rate, pretax rate of return, and inflation rate are the expected, on-average values from now until retirement, for the tax rate, or until the death of the last surviving spouse, for the rate of return and inflation rate. Figure 2 ********* GENERAL PARAMETERS ********** 1> CURRENT YEAR 1986 2> CURRENT AGE OF SPOUSE A 53 3> CURRENT AGE OF SPOUSE B 50 4> NO. OF YEARS UNTIL RETIREMENT 7 5> EXPECTED MORTALITY AGE OF SPOUSE A 89 6> EXPECTED MORTALITY AGE OF SPOUSE B 88 7> EXPECTED, ON-AVERAGE MARGINAL INCOME TAX RATE (%) 42 8> EXPECTED, ON-AVERAGE PRE-TAX RATE OF RETURN (%) 10 9> EXPECTED, ON-AVERAGE INFLATION RATE (%) 6 Next, specify the current and anticipated (i.e., desired) post- retirement annual expenditures (see Figure 3). Be as detailed as necessary in order to account for every current and anticipated future expense category. In particular, be sure to note taxes (including income, property, and other taxes) and miscellaneous incidental expenses ("cash"). The anticipated post-retirement figures should represent the average annual expenditure in each category from the year of retirement until the year when the last surviving spouse dies. Figure 3 ********* ANNUAL EXPENDITURES ********* POST- CURRENT RETIRE 1> FOOD 5000 4000 2> CLOTHING 2500 1000 3> HOUSING 12000 4000 4> TRANSPORTATION 5000 2000 5> UTILITIES 3000 3000 6> MEDICAL 1500 3000 7> ENTERTAINMENT 3000 3000 8> VACATION 1000 3000 9> COMPUTER 5000 500 10> TAXES 25000 5000 11> CASH 2000 1500 ------ ------ TOTAL 65000 30000 After specifying your annual expenses, you must indicate your current existing working capital, its anticipated annual rate of growth, and any liabilities you anticipate at retirement (see Figure 4). Figure 4 ******** NET WORKING CAPITAL ********** 1> CURRENT EXISTING WORKING CAPITAL ($) 350000 2> GROWTH RATE FOR EXISTING WORKING CAPITAL (%) 7 3> ANTICIPATED LIABILITIES AT RETIREMENT ($) 0 Next, you specify pre-retirement future savings out of income ("annual cash flow margin"), pension and IRA contributions, and any other funds set aside for retirement purposes (see Figure 5). Figure 5 ** PRE-RETIREMENT FUTURE CASH FLOWS *** 1> ANNUAL CASH FLOW MARGIN --BEGINNING VALUE ($) 24000 --ANNUAL RATE OF INCREASE (%) 0 --YEAR FLOW BEGINS -6 --YEAR FLOW ENDS 0 --PRE-TAX RATE OF RETURN (%) 10 --RETURNS TAXABLE (Y/N) Y 2> QUALIFIED RETIREMENT PLAN --BEGINNING VALUE ($) 8000 --ANNUAL RATE OF INCREASE (%) 3 --YEAR FLOW BEGINS -6 --YEAR FLOW ENDS 0 --PRE-TAX RATE OF RETURN (%) 10 --RETURNS TAXABLE (Y/N) N You can enter years in absolute terms (e.g., 1987) or you can enter them as the number of years relative to the retirement year. If you enter absolute years, the program will automatically convert them to relative years (1987 converts to -6 in this example). Thus, if retirement is to occur seven years from now, in relative terms the current year is -7 (1986), the retirement year is 0 (1993), John's Social Security is due to begin in year 5 (1998, five years after retirement, when he will be age 65), etc. If you get confused, just go to the age/time table (see figure 6) to see the matchup between both spouses' ages and the corresponding absolute and relative years. Figure 6 *********** AGE/TIME TABLE ************ -------YEAR------- AGE OF AGE OF ABSO- RELATIVE TO SPOUSE A SPOUSE B LUTE RETIREMENT 53 50 1986 -7 54 51 1987 -6 55 52 1988 -5 56 53 1989 -4 57 54 1990 -3 58 55 1991 -2 59 56 1992 -1 60 57 1993 0 61 58 1994 1 62 59 1995 2 63 60 1996 3 64 61 1997 4 65 62 1998 5 66 63 1999 6 67 64 2000 7 ENTER B TO BACK UP, C TO CONTINUE OR 0 TO RETURN TO MAIN MENU? For consistency's sake, you might want to set the pre-tax rates of return for each flow equal to the figure specified under "general parameters" (main menu, item 1), although you can specify individual rates of return if you wish. Specify, also, whether returns on pension contributions and savings for retirement are taxable. IRAs are one example of a non-taxable cash flow. Post-retirement income sources--including Social Security, pension benefits, rental income, etc., but excluding returns from retirement capital and savings (such as dividends and interest)--are specified in a similar fashion (see Figure 7). Figure 7 ***** POST-RETIREMENT CASH FLOWS ****** 1> JOHN'S SOCIAL SECURITY --BEGINNING VALUE ($) 12601.24 --ANNUAL RATE OF INCREASE (%) 2 --YEAR FLOW BEGINS 5 --YEAR FLOW ENDS 29 2> MARY'S SOCIAL SECURITY --BEGINNING VALUE ($) 6686.27 --ANNUAL RATE OF INCREASE (%) 2 --YEAR FLOW BEGINS 8 --YEAR FLOW ENDS 31 3> DEFINED BENEFIT PLAN --BEGINNING VALUE ($) 6000 --ANNUAL RATE OF INCREASE (%) 0 --YEAR FLOW BEGINS 5 --YEAR FLOW ENDS 29 You will note that the beginning value of John's Social Security annual benefit is $12,601.24, not $9,936, which is the value of his benefits if he were receiving them today. The beginning value refers not to the current value but instead to the value of the income source in the year it actually begins. RETIRE comes equipped with a compound growth calculator (see Figure 8) for calculating the future value of known current amounts. Using the calculator, you will find that, at 2% annual growth, $9,936 will grow to $12,601.24 by year 5 (1998, when John will be 65); and that Mary's initial Social Security benefit (currently $4,968) will grow to $6,686.27 by year 8 (2001, when she will be 65). (You might also use the growth calculator to observe the inflationary growth of anticipated expenditure figures between now and the end of the retirement period.) Figure 8 *********** COMPOUND GROWTH *********** -------YEAR------- RATE OF COMPOUND ABSO- RELATIVE TO GROWTH VALUE LUTE RETIREMENT 2 9936 1986 -7 2 10134.72 1987 -6 2 10337.41 1988 -5 2 10544.16 1989 -4 2 10755.04 1990 -3 2 10970.15 1991 -2 2 11189.55 1992 -1 2 11413.34 1993 0 2 11641.6 1994 1 2 11874.43 1995 2 2 12111.92 1996 3 2 12354.16 1997 4 2 12601.24 1998 5 2 12853.27 1999 6 2 13110.33 2000 7 ENTER B TO BACK UP, C TO CONTINUE, R TO REFIGURE, OR 0 TO RETURN TO MAIN MENU? Note, too, that unlike for pre-retirement cash flows, there is no need to indicate post-retirement cash flow rates of return and whether or not post-retirement returns are taxable. The model accounts for these factors implicitly. Finally, it is time to compute the retirement-year capital requirement or surplus (see Figure 9). The projected capital surplus at retirement is computed to be $147,442.30, which is essentially identical to Mr. Leonetti's results (the slight difference is due to rounding). The additional amount John and Mary can spend each year from now until retirement and still meet their post-retirement expenditure objectives is $17,672.99. (If you now specify an additional pre-retirement cash flow, called "dissaving," valued at minus $17,672.99, growing 0% per year, beginning in year -6, ending in year 0, with a rate of return of 10%, and taxable, the recomputed capital surplus is $.02--virtually zero, as you might expect.) Otherwise, if John and Mary make no savings/dissavings adjustment, they will be able to afford an expenditure level of $35,135.33 (stated in terms of current prices) throughout the post-retirement period. (Without any adjustment to pre-retirement savings, if instead you specify $35,135.33 as their anticipated post-retirement annual expenditure figure, the recomputed capital requirement is $.02--again, nearly zero.) Figure 9 ***** CAPITAL REQUIREMENT/SURPLUS ***** YOUR PROJECTED CAPITAL SURPLUS AT RETIREMENT ($): 147442.3 THE AMOUNT YOU CAN DISSAVE EACH YEAR UNTIL RETIREMENT AND STILL MEET YOUR EXPENDITURE OBJECTIVES ($): 17672.99 OTHERWISE, THE POST-RETIREMENT ANNUAL EXPENDITURES (IN CURRENT DOLLARS) YOU CAN ACHIEVE WITH NO PRE-RETIREMENT SAVINGS ADJUSTMENT ($): 35135.33 To see why inflation is the bane of every retiree, go to the general parameters menu and increase the anticipated inflation rate just a notch, from 6% to 7%. John and Mary's anticipated $147,442.30 retirement-year capital surplus now turns into a $28,464.64 deficit, and their sustainable average annual expenditure falls to $29,176.73. Higher rates of inflation are downright impoverishing. (On the other hand, as inflation rates increase, overall rates of return on capital should rise as well, something you should keep in mind when testing the impact of inflation.) You can play "what-if" with the program data to your heart's content, but when changing dates, be careful. If you were now to indicate 12 years until retirement, which would change the retirement year from 1993 (when John will be 60) to 1998 (when he will be 65), since John's Social Security is said to begin in year 5 (five years after the retirement year), the implication is that he would not begin receiving Social Security until 2003, when he will be 70; and since his benefits are said to end in year 29, by implication they would continue until the year 2027, five years beyond his expected death! (You can verify all this by inspecting the program's age/time table.) To correct the situation, you must now specify that John's Social Security benefits begin in year 0 and end in year 24. Similar adjustments will have to be made to Mary's Social Security and their defined benefits schedule. (Remember, also, to change the beginning value all post-retirement cash flows where necessary.) When playing around with dates, therefore, the moral of the story is to think carefully about what you are doing, and double-check all of your figures. RETIRE conforms to the rule of GIGO: "garbage in, garbage out." (There are good reasons not to make all time adjustments interactive and automatic, in case you're wondering.) The RETIRE program has been tested extensively and validated against a parallel spreadsheet model (one that calculates income, expenditure, and accumulated capital figures explicitly, year by year). Don't accept the results you get as the gospel truth, however. As complicated as this planning method is, it nonetheless depends on a number of simplifying assumptions. Furthermore, there is no way one can know with certainty what the inflation rate will be over the next 30 years, whether the Social Security system will go belly-up by the next century, or if advances in geriatric medicine will enable you and your spouse to long outlive your retirement capital. Thus, it is better to be conservative, and set more aside for retirement than the program results might suggest. Still, the RETIRE program will help sharpen your foresight. After using it, you should be able to face the uncertainties of retirement with greater confidence than before. Robert Osterlund