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Rethinking Retirement

Plan for Retirement Like a Pro

Actuaries use present value to calculate the worth of future payouts. But people who wouldn't know a calculator from a remote control can use it, too.

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I've always been a horrible decision maker. My approach is to over-research, change my mind a few times and, if possible, kick the can down the road. This tendency to dither makes retirement planning a challenge. Should I count on working longer or retiring on a particular date? Downsize or stay put? Save like crazy or splurge while I can still enjoy it?

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Now an actuary has suggested a way to put some method into this decision-making madness. In his recent book, What's Your Future Worth?, Peter Neuwirth describes how to translate the actuarial concept of present value into retirement decisions.

Present value assigns a current value to possible future outcomes. Actuaries use the concept to calculate the worth of future payouts, such as pensions. But people who wouldn't know a calculator from a remote control can use it, too, says Neuwirth. "Every time you're faced with the decision to save or spend or invest or withdraw money, you need to look at the future consequences of that decision and understand what's important to you now and in the future."

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Putting it into play. As Neuwirth explains, the process boils down to five steps:

1. Define your choices.

2. Imagine as many outcomes as you can for each choice.

3. Evaluate the likelihood of each outcome.

4. Weigh the value to you of a result that happens in the near future (say, covering your kid's college bill) with those in the more distant future (for instance, having enough money to fund your retirement).

5. Apply a discount to the value of events further out to account for their uncertainty, including the impact of inflation, and because you have to wait to use the resource.

Let's apply the process to a real-world decision: when to claim Social Security. Say you define your choices as taking benefits at 62 (with a 25% reduction) or at 66 (for the full amount). Consider the possible outcomes: You'll quit working and claim at 62 and then lose all of your savings in a stock market crash. You'll claim at 66 and die the next year, leaving money on the table. You'll live to 100 and beat the system. Or Social Security will fold before you get your share.

The beauty of this exercise is that it encourages you to consider all the outcomes, not just the ones you naturally gravitate to, says Steve Vernon, an actuary who is a consulting research scholar at the Stanford Center on Longevity. "A lot of people focus on one possibility and let it drive their behavior. They either ignore good potential outcomes or focus on bad potential outcomes."

Once you've looked at every scenario, consider the likelihood of each one. Stock market crash? It's possible, but you wouldn't lose every nickel. Die sooner or later? If you're healthy and your parents both lived into their nineties, later is more likely. Social Security folding? Not gonna happen, you conclude. Throw out the unlikely scenarios, and decide how much each of the others is worth to you, remembering to apply a discount (how much is up to you) to events in the distant future.

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Some decisions, such as whether to use a chunk of money to pay off your mortgage or keep it invested, become clearer once you do the math, factoring in interest rates, potential investment earnings and inflation. Even then, evaluating your priorities is key, says Neuwirth. If you place a premium on owning your home outright, for instance, you might assign a greater present value to the money you will save in mortgage payments than to what you could earn if you invested the money, even if that dollar amount is higher. Or you might decide you'd rather keep the mortgage and let that money grow.

There's no right answer, says Neuwirth. "At the end of the day, you have to go with your gut. If you take the time to think the decision through, you'll have a smarter gut."