One of your high-priority life goals would be to retire comfortably. Attaining that requires a lot of effort from your side. One, you need to know how much wealth you will require at retirement.
Two, you have to identify appropriate investment products to buy during your working life to achieve the required wealth at retirement.
In this article, we discuss why life expectancy is an important factor in determining the wealth you require at retirement and the consequences of overestimating or underestimating the number!
Life expectancy is the number of years you are likely to live. This factor is important because the amount of money in your investment account at retirement should be enough to sustain your post-retirement living.
So, can you err on the side of caution and assume that you will live till 100? That way, you would be able to accumulate enough wealth to ensure that you will never be short of money in your retired years. Not really.
If you were to assume that your life expectancy is 100 and you expect to retire at 60, you will have to accumulate enough money in your investment account to support 40 years of retired life.
This means you need to deposit more money into your retirement account during your working years than if your life expectancy were only 90.
If you started your career at 22, 38 years of your working life would have to support 40 years of retired life.
That is, for every one year of your working life, you need to set aside money for approximately one year of retired life, besides meeting your current living expenses! Therefore, it is not necessarily good to overestimate your life expectancy.
Underestimating your life expectancy leads to a different kind of risk. Suppose you estimate that you are likely to live only till 85 and, accordingly, accumulate wealth in your retirement account.
What if you survive past 85? The risk that you will live beyond your life expectancy is called longevity risk — the risk that you will outlive your investments. Clearly then, overestimating or underestimating your life expectancy can cause issues during your retired life.
Of course, between the two, it may be better to overestimate your life expectancy than underestimate it. So, how should you estimate your life expectancy?
Not needed?You need to know your life expectancy if you consume your investment capital as well as income returns during your retired life.
But what if you meet your post-retirement expenses from only your investment income?
Suppose you invest in bank fixed deposits and choose to meet all retirement expenses (including medical) from the interest income.
In that case, you need not estimate life expectancy to decide how much wealth you will need at retirement.
Instead, you simply have to do the following: inflation-adjust your current living expenses to your retirement years.
Then, calculate the amount you require to invest in fixed deposits to earn income to meet the inflation-adjusted expenses.
Of course, you need to adjust this required amount continually — whenever income return (interest rate) decreases or price (inflation) increases.
The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in