Planning with Uncertainty – When can we retire? Or How much is Enough?

As we consider retirement we want to plan prudently and arrange our affairs wisely. But results depend on future conditions that can’t be exactly predicted. We must consider questions like -- How long will we live? What rates of return will investments earn? How much inflation will there be?

Uncertainty about the answers to questions like these don't make planning impossible or less useful -- just more complicated. Prudent planning means considering the various possibilities that could result and selecting as our plan the course of action with the consequences we like best.

For example, should we retire in 2009 after I turn 62, if we –

• have $400,000 in mutual funds

• no house payments

• can receive $18,000 per year in social security benefits

• spend $45,000 a year.

Is that enough to retire? What does "enough to retire" mean? And how do we figure out whether this amount is enough?

When we ask, “Is that enough?” we mean, “Is that enough assets so that they will not be used up before we die?” And we figure this out by doing calculations to see how long the assets will last and comparing the result with how long we are likely to live.

To calculate how long our assets will last we need to use their rates of return, inflation rates, and know how inflation will affect our social security benefits and spending. Even though these values can’t be reliably predicted we must use them to carry out the calculations.

There are several techniques for producing values to use in the calculations. A common approach is picking a single “average” value for each variable we need and then making the calculation as if the variables would stay constant at those values. The term “average” is placed in quotes because sometimes mathematical averages are calculated and used for the variables, and other times values are used that represent expectations about average future conditions. The calculation procedures are the same in either case. My next post will explain an example using this approach.