Once we retire, we have a fundamental problem – how do we go about providing our income needs?

Typically, many people see this as solely about how well our savings are invested. This is certainly part of the problem but it isn’t the whole story.

Series of cashflows

Our retirement spending needs are really just a series of future cash flows. But this is not a set-and-forget problem.

For example, suppose that before retirement, I estimate that my wife and I will need $100,000 a year combined to live on.

Now my future cash flow needs aren’t simply $100,000 each year for however long I estimate we’ll both live.

We have to factor in the well-known matter of inflation. If we assume that prices will increase by 3% each year, then in effect, we’re assuming that prices will double over 24 years. That is, something that costs $1 today will actually cost $2 in 24 years’ time.

To work out how quickly prices will double based on an assumed inflation rate, we can use a simple calculation called the “rule of 72”.

Effectively divide 72 by your preferred inflation rate and you’ll get the number of years it takes for prices to double. That is, 72 divided by 3 equals 24.

Here’s another example: consumer inflation in Australia has doubled between March 1989 and today – that is about 27 years. So our average inflation rate has been lower than 3% each year. This is actually an average inflation rate of 2.6% each year.

Our assumed price increase

Based on the above, I guess most people would be happy to have their retirement income increase by consumer inflation.

But is this suitable?

To answer this, we need to know what inflation is. It is simply a measure of how quickly a basket of common consumer goods have increased in price. It’s not a measure of improvements in living standards.

A good example of this is mobile phones. Twenty years ago, a minority of the population had a mobile whereas now very few Australians don’t have one or more of these devices. It’s not uncommon for people to spend $100 per month or more on their mobile phone contract. This is an additional expenditure that only real increases in income can allow unless we cut back on other expenses to allow for a new one.

So how can we measure living standard improvements? The government method for solving this dilemma is indexing the age pension by movements in average weekly wages.

Typically, wages increase faster than consumer inflation.

There have been a few brief periods when consumer inflation has increased faster than wages and there have also been other periods when consumer inflation has fallen (this has never happened to average wages).

By way of comparison with price inflation, average wages have doubled between June 1999 and now – that is roughly 17 years, or an average increase of 4.2% each year.

What’s included in your income needs?

Working out our future retirement cash flow demands that we determine some unique features:

• As we’ve discussed, our price increase assumptions.
• One off expenditures such as new travel, motor vehicles, house renovations or repairs, medical expense, etc.
• Our changing lifestyle. For example, as we age, our spending may well decline as we lose physical capacity.
• Uncertainty as to how long we will live.

Each quarter the Association of Super Funds of Australia (ASFA) produces some estimated retirement income numbers. For example, a couple looking for a comfortable retirement needs just under $59,000 in March 2016. Importantly, these numbers assume you own your home and have no debt.

Everyone will have their own unique budget and you should know what yours is, with as much detail as possible.

Quantifying the impact of our selected inflation

Above I said let’s assume my wife and I need $100,000 on which to live on in retirement. Now also assume that we’ll live for another 30 years. Without taking inflation into account, that’s income needs of $3,000,000. That sounds a lot and it certainly is.

But if we assume 2.6% inflation – that is the inflation average for the last 27 years – then our total income payments increase to $4.4 million.

If we assume a 4.2% yearly increase in income needs – that is the wages increase average for the last 17 years – then our total payments increase to $5.8 million. The bottom line is that we need our investments to generate some significant income over our retirement years.

Declining income needs as we lose physical capacity

It’s commonly accepted that as we get older, we’ll become more infirmed and therefore have less need to spend money.

For example, ASFA assumes that once we reach age 85, we’ll be spending about 90% of that amount spent by retirees who are 20 years younger.

It’s reasonable to assume that we will all lose some mental and physical capacity. But research published by the Australian Institute of Health and Welfare has found that medical advances and other influences (such as diet and occupations) are reducing the years we will suffer severe infirmity later in life.

Uncertainty of how long we will live

It’s long been known that Australians are living longer.

But it’s important to quantify how rapid this increasing life expectancy actually is.

In 1960, a 65-year old male had an average life expectancy of 12.47 years and a female 15.68 years.

The most recent life tables (for 2010/12) show that a male can now expect to live 19.22 years and a female 22.05.

So over 50 years, male life expectancy has increased by 6.75 years and females by 6.37 years.

Actuaries accept that for several decades they have been under-estimating how long people might live because medical advances and other factors have been increasing life expectancies faster than they have anticipated.

Accurium, an actuarial firm, has estimated that at least one member of a couple, husband and wife who are both aged 65, have a very good probability of seeing 100 years of age. That is, one of them will live for at least another 35 years.

On this basis, it’s best to assume we will live longer than our older relatives and possibly longer than we reasonably expect.

So our retirement income should cater for improving living standards, take into account our one-off expenditures, and also be enough to pay us some money for an uncertain number of years, which may be longer than we expect!

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.