Overview
One of the primary uses of financial analysis is to analyze retirement finances. In particular, how much money is needed in retirement in order to live comfortably. This corner details some of the models and analytics used when answering this question.
The Retirement Problem
Assume that an individual will work for a given number of years. They will consume a portion of their income and save a portion. Then they retire and will live off their savings.
The question that needs to be answered is: What is the likelihood that they run out of money prior to dying?
There are several variables in this analysis that can change the outcome.
- Number of Working Years
- Savings rate during work
- Consumption rate in retirement
In addition to these variables, there are other variables that may not be under the control of the retiree.
- Salary during Working Years
- Returns earned on savings
Visualization
A visualization of the retirement problem. Total wealth increases prior to retirement as the individual works and saves, and then wealth decreases during retirement as the individual consumes their savings.
Solution Methods
One of the primary method ways to tackle the retirement problem is to split it into two different problems.
- Calculate the amount of money needed, starting at day one of retirement
- Calculate how much money you need to save each year of your working life to hit the target amount
Both methods will typically ignore inflation. That is, forecasts typically assume that all rates are stated on a real basis.